In a world where out-of-pocket healthcare costs are rising, and the deductibility of medical expenses is limited to rare circumstances, either a health savings account or a flexible spending account can be a valuable workaround.
Each account provides a tax-deductible way to have funds available for medical expenses.
It doesn’t reduce the out-of-pocket cost of healthcare, nor can either be used to cover health insurance premiums themselves.
But they can at least enable you to get a tax break on at least some of your out-of-pocket costs.
Health Savings Accounts (HSAs)
What is the tax advantage of an HSA?
HSA accounts are basically medical IRAs, and they work in much the same way.
Contributions to an HSA are fully tax-deductible, as long as you have sufficient earned income that matches or exceeds the amount of the contribution.
You can contribute up to $3,450 if you’re single, or up to $6,900 for a family for 2018. The contribution limits are increased by $1,000 if you are 55 or older.
The contribution amount reduces your federal income tax liability, and usually your state income tax liability as well.
It does not, however, reduce your income for FICA tax purposes.
How does an HSA work?
An HSA must be set up in conjunction with a high deductible health plan.
There are minimum deductible amounts, as well as maximum out-of-pocket amounts.
For 2018, these limits are an annual deductible of not less than $1,350 for self-only coverage, or $2,700 for family coverage.
Out-of-pocket expenses, including deductibles, copayments and other amounts (but not including health insurance premiums) cannot exceed $6,650 for self only coverage, or $13,300 for family coverage.
The plan is available to individuals, the self-employed, or employees as part of an employer-sponsored plan.
Contributions are generally made by the individual, but they can also be made by the employer in a sponsored plan.
They can even be made by both the employee and the employer.
HSA funds are generally held in a bank account, which enables you to access the funds through either a debit card or by check.
The funds are eligible for withdrawal to pay for qualifying medical and dental expenses, as well as insulin and prescription drugs.
Distributions taken to pay for nonqualified expenses are subject to ordinary income tax, plus a 20% penalty.
Who is an HSA best for?
An HSA is an excellent plan for anyone, especially given the rising cost of out-of-pocket medical expenses.
But they are particularly well-suited for those who have a predictable need for medical care.
They provide an opportunity to allocate tax-deductible funds for medical expenses not paid by your insurance plan.
They are probably not well-suited for someone who is young and healthy, and unlikely to incur medical expenses. Funds can only be withdrawn from an HSA for qualified medical expenses.
It’s possible that thousands of dollars can be accumulated in a plan, with no immediate ability to use or withdraw the funds.
Do funds roll over from year to year?
Any funds in your HSA that have not been used in the current year, can be rolled forward.
In fact, they can be carried forward indefinitely. They can even be invested.
They’re usually held in an interest-bearing bank account, but if you have an individual plan, you can also choose to invest the money in an investment account, similar to an IRA.
Where does an HSA fit in your savings strategy?
Naturally, you should always have an emergency fund as a savings account.
You should also always have a retirement plan in place and being funded regularly.
Exactly where an HSA fits in the mix depends on your personal needs. Once again, if you have a regular need for medical care, an HSA will fit somewhere between your emergency fund and your retirement plan.
Since you know you’ll need the money, the HSA can prevent you from needing to access your emergency fund or retirement plan.
If you’re not likely to need medical care, an HSA may be third in line, behind an emergency fund and a retirement plan.
The best way to use an HSA?
One of the best uses for an HSA is to build it up in the years just before retirement.
Since medical expenses typically increase with age, you can use an HSA to accumulate funds to cover medical expenses in the retirement years.
This will help to insulate your other savings from medical costs.
Flexible Spending Accounts (FSAs)
What is the tax advantage of an FSA?
Contributions made to an FSA are fully tax-deductible.
However, exactly who takes the deduction depends on who funds the account.
It can be either the employer, the employee, or both if each contributes.
The FSA annual contribution limit is $2,650 for 2018.
How does an FSA work?
FSA’s are only available through employers.
Unlike an HSA, an individual or self-employed person can’t set one up (though the self-employed person can, if he or she has employees).
The account is funded either by the employee, the employer, or both. It can be used to cover the same medical expenses as an HSA.
Who is an FSA best for?
An FSA can work for anyone, but it is only available as part of an employer plan.
Generally speaking, if you have the option between an FSA and an HSA, the HSA will be the better plan because of the higher contribution amount, and the fact that the funds can be carried forward from year-to-year.
There is an exception. If the FSA is fully funded by the employer, it might be the better of the two plans.
This will be particularly true if you’re on the lower end of medical expense needs.
Do funds roll over from year to year?
Generally speaking, they do not, which makes the FSA completely different from the HSA in this regard.
The general rule is that any money contributed to an FSA that has not been withdrawn within the same year, will be forfeited (retained by the employer).
However, the employer may offer one or both of the following exceptions:
- A 2.5 month grace period after the end of the plan year, during which the carryover funds must be used for eligible medical expenses, and/or
- The ability to carry up to $500 into the next plan year. If this is offered, it will be in addition to your regular contribution, and not a reduction in that amount.
In either case, the carryover provision is much more restrictive than it is for an HSA.
Where does an FSA fit in your savings strategy
You would have an FSA for all the same reasons you would an HSA. If you have predictable medical costs, it’s worth having.
However, if not, there’s a real possibility you’ll forfeit the money contributed to the plan.
It makes the most sense when the employer is fully funding the account. In that situation, it’s a full-fledged employee benefit, and well worth having.
Otherwise, there is a real potential that it will take funds away from other savings priorities, like an emergency fund or retirement.
Best way to use an FSA?
Since an FSA can’t be carried forward, it has no place in your long-term retirement planning.
But if it’s offered by your employer, there’s no HSA option, and the employer will fund some or all of the plan, it will be worth having.
Which Account Should You Use?
The table below shows a side-by-side comparison of the highlights of each of the two plans.
If you don’t have an employer offering either plan, you will only be able to take an individual HSA.
But if your employer offers you both plans, the table will help you make the choice.
HSA vs. FSA
|Category||Health Savings Account||Flexible Savings Account|
|Plan Eligibility||Available for employees, individuals, and the self-employed. Must participate in a high deductible health plan, with a minimum copayment of $1,350 for an individual, or $2,700 for a family. Out-of-pocket maximum cannot exceed $6,650 for a single, or $13,300 for a family.||Plan established by employer (not available to individuals or the self-employed). Not subject to high deductible health plan requirements.|
|Annual Contribution Limits||For 2018, $3,450 for singles, $6,900 for families. An additional $1,000 if you are 55 or older.||$2,650 per employee.|
|Contributions Provided By...||Individual in a private account, but either employee, employer or both in an employer-sponsored plan.||Can be funded by either the employer, the employee or both.|
|Who Owns the Account?||The employee or individual.||The employer.|
|Account Access||The employee or individual, subject to the amount deposited in the account.||The employee. Can access up to their annual election amount, even if the account is not yet fully funded.|
|Unused Funds||Can be rolled over from one year to the next.||Generally retained by the employer, who may offer a 2.5 month grace period after the end of the plan year and/or ability to carry up to $500 into the next plan year.|
|Required Documentation||Participant must keep records supporting of distributions taken from the plan. Records must be available upon IRS audit.||Employee must submit third-party documentation of expenses, as well as evidence said expenses are not covered by another plan.|
|Contribution Amount Changes||Participant may contribute as little or as much as desired, up to the plan contribution limits.||Employee establishes contribution amount at the beginning of the year, but can make changes based on a change in family status.|
Can you contribute to both plans? Generally speaking, you can only participate in one or the other.
However, there is an “HSA compatible FSA” option. If your employer does offer it, the FSA is only available for certain expenses, such as vision and dental.
In that case, you’ll get the increased tax deduction by participating in both plans.
Given the prospect of rising healthcare costs, and especially rising out-of-pocket costs, you should take advantage of either plan, if it’s available.
In most cases, the HSA will be the better choice. But absent an HSA option, an FSA will be a viable alternative.
This is especially true if your employer will fund part or all of the annual contribution.