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What is a Health Savings Account and How Does it Work?

Posted on by Dawna M. Roberts in LawApril 25, 2023

Health insurance can be difficult to understand. Deductibles, copays, drug coverage, and types of plans get complicated. Health savings accounts are part of the mix: they’re ways to put money aside for medical expenses. They are different from Flexible Spending Accounts, which may be used for the same purpose.

Health Savings Accounts are most often used by people with high deductible healthcare plans through an employer, but self-employed individuals may open an account too. Some create accounts because they have medical issues or are anticipating a major medical expense. In order to create one, you ask your employer’s human resources office to divert some of your pay to this special account, which is not taxed as income.

Investment advisors call HSAs “triple advantage” accounts because they are ways to reduce the individual’s taxable income, the account deposits are tax-free, and money from the HSA may be spent without incurring taxes. There are $82 billion in assets in these accounts in the US.

In the United States, Health Savings Accounts were created as part of the 2003 Medicare Prescription Drug, Improvement, and Modernization Act, but did not become popular among consumers for about a decade.

How Does a Health Savings Account Work?

health savings account

A Health Savings Account allows you to pay your portion of the medical-related expense with untaxed income directly from the account. The account holder’s dependents (declared on federal income taxes) may also be covered by this account. Unlike a Flexible Spending Account, which can also be used for medical expenses but must be used within a year, an HSA will roll over year after year. California, New Jersey, and Alabama count HSA contributions as taxable income under state taxes.

In order to qualify, an applicant must follow the Health Savings Account rules:

  1. The applicant must be enrolled in a high-deductible health care plan.
  2. The applicant cannot be on Medicare.
  3. The account holder cannot be a dependent on another person’s tax return.
  4. The account holder cannot have other/additional health care plans.

The Internal Revenue Service publishes a document, 502, that describes who can be covered by HSA spending as well as which medical and dental services and related expenses the account can be used for. The IRS is involved because some HSA expenditures are tax deductible (they must be claimed on Schedule A of Form 1040, and expenses must be more than 7.5 percent of the individual’s adjusted gross income).

While those who work for others may have their contributions matched by their employer, self-employed and sole proprietors may open HSA accounts through a bank. Their deposits may be made at any time and do not have to meet a minimum per year. Investing these funds is determined by the terms of the account creator (employer or bank) and must include a trustee.

Among the permitted services and procedures covered by an HSA are abortions, alcoholism treatment, lead paint removal from your home, improvements to enhance home accessibility such as ramps, wider doorways, and accessible bathrooms; changes to your vehicle that allow you to continue driving with a medical disability, wages of home health aides, the cost of false teeth or a prosthetic limb, fertility treatments, psychotherapy, and more. Money withdrawn and used on non-medical expenses may incur a 20 percent penalty.

Benefits of a Health Savings Account

Average Americans spend up to $5,000 out of pocket on medical expenses each year. These include prescription drugs, urgent care clinic visits, copayments, hardware like crutches or braces, and even meals and transportation related to hospitalizations. A health savings account can save money on these expenses by eliminating taxes associated with paying medical bills.

Unlike other kinds of medical savings accounts that have to be spent within a calendar year, an HSA rolls over year-to-year. When the owner changes jobs, the HSA remains in their name.

In terms of investment, an HSA is a way for individuals to skirt rules on maximum contributions. Roth accounts, 401(k) accounts, and other retirement/investment accounts have strict limits on the amounts that can be deposited each year, but an HSA is a separate entity, offering another way to reduce taxable income and grow interest or multiply the principle tax-free.

After age 65 and Medicare enrollment, the funds in an HSA account can be used or withdrawn for any reason. The HSA allows spending on home health aides and other age-related medical expenses but no contributions may be made to the account if the individual is receiving Social Security income. The IRS will check vital records to ensure an account holder is age-qualified to make such withdrawals.

Upon the account holder’s death, the account may be taken over by a spouse or other beneficiary named on the account. Without a beneficiary named, the heirs of an account holder may not learn of an HSA account unless an asset search is conducted.

Disadvantages of a Health Savings Account

health savings account

Fewer than 20 percent of Americans have an HSA account, and those are most likely to be affluent individuals. It’s more difficult for working-class people to divert a percentage of their income to future medical expenses unless there is a clear need.

Creating an HSA requires a new level of tax reporting to the Internal Revenue Service, which regulates how funds from these accounts may be used. This means saving medical receipts and records and filing a Schedule A with your federal taxes each year.

HSA Contribution Rules

  1. The individual must be enrolled in a high deductible health insurance plan, usually a “bronze” level plan with a $1,500 annual deductible for an individual and $2,800 for a family.
  2. There are limits to how much money can be deposited in an HSA account each year. In 2023, an individual account deposit limit was $3,850, and a family limit was $7,500. After age 55, an additional $1,000 per year can be added.
  3. It is possible to invest the funds in HSA accounts in the stock market or other traditional investment vehicles, but the IRS requires a Schedule A to be completed with the individual’s tax return.


HSA accounts are used by 30 million Americans, with an average balance of over $4,000. The average account holder has an income around $74,000. While HSA accounts are beneficial to a wide swath of Americans, it’s unlikely that the lower-earning segment of the population can access them because deferring even a modest portion of earnings into investment is challenging.

For middle-of-the-road earners, it’s a matter of calculations: will the tax savings and potential investment growth make a significant difference over time? Investment advisors say the benefits of an HSA are not felt in the first five years.

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