A health savings account (HSA) is a tax-sheltered plan, allowing both tax-deductible contributions and tax-free distributions. In order to gain these tax benefits, certain qualifications must be met.
To qualify to make contributions to an HSA, a person must be covered by a high deductible health insurance plan. These plans tend to involve lower premiums, but higher deductibles (as the name suggests). Additionally, the person may not be covered by Medicare or be claimed as a dependent on any other person’s tax return. If all the necessary qualifications are met, HSA contributions may be made. The contributions are deductible (sometimes referred to as pre-tax), meaning the amount of contributions made is deducted against the person’s earned income, resulting in lower income taxes.
Once the contribution is in the account, it can be invested in a wide variety of securities. This includes common stock, preferred stock, bonds, mutual funds, and exchange traded funds (ETFs). The assets grow on a tax-deferred basis, meaning any investment gains cannot be taxed until money is distributed from the account.
The primary purpose of an HSA is to help with medical expenses. Once a qualified medical expense occurs, a person may withdraw money from their HSA to pay for it. Good news - the money withdrawn is not subject to any taxes as long as it’s used for qualified medical expenses. If HSA money is not used for qualified expenses, distributions are subject to ordinary income taxes plus a 20% penalty*.
*Although lightly tested, there are two exceptions to the 20% penalty. This penalty does not apply when the account owner turns age 65 or qualifies as disabled (as per IRS requirements). Regardless, the IRS still considers the distribution to be taxable ordinary income.
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