HSAs and Their Tax Consequences

HSAs

An HSA is a savings account used to pay for out-of-pocket medical expenses. Contributions to your HSA are either tax-deductible (similar to deductible IRA contributions) or made pre-tax if the HSA is offered through an employer's benefit plan (similar to 401(k) contributions). Earnings in the account are not taxed, and distributions from the account that are used to pay for qualified medical expenses are tax-free. To be eligible to contribute to an HSA, you must have a high-deductible health plan, or HDHP. The HDHP:

must have a high deductible; for 2009 the minimum deductibles are $1,150 for self-only HDHP coverage and $2,300 for family coverage.

must not pay medical benefits until the deductible is satisfied. For example, a medical plan that pays for prescription drugs or office visits without regard to the deductible is not a qualifying HDHP.

There are, however, exceptions for preventative or "wellness" benefits, such as basic health check-ups, maintenance drugs, cancer screenings, etc.

Other eligibility requirements:

You must not be a dependent on another person's return, you may not have any other type of health insurance coverage, and you may not be enrolled in Medicare. Certain "permitted coverage" is allowed, including dental, vision and long-term care insurance. There is no earned income requirement.

If you meet all of the requirements, you may contribute up to $3,000 ($5,950 if you have family HDHP coverage) to your HSA. If you are at least age 55, you may contribute an additional $1,000. You may use your HSA funds tax-free to pay for out-of-pocket medical expenses including doctors visits, prescriptions and over-the-counter medicines, laboratory tests and hospital stays. But if you use HSA funds for some other purpose, the distribution is subject to tax at ordinary rates and, if you are younger than 65, a 10% penalty. The HSA/HDHP combination is not for everybody because of the high deductible. If you are taking several prescription medications or if you expect to visit the doctor several times, you would have to pay a great deal out-of-pocket until your HDHP deductible is met. Or, you may not have enough to be able to fund an HSA. But if your medical expenses are relatively low and you are able to contribute consistently to an HSA, consider all of these advantages in addition to the tax advantages:
HSA funds are not "use or lose," unlike flexible spending accounts (FSAs). You may keep the funds in the account as long as you wish and use them only when you need to.

Unlike Roth IRAs, there is no waiting period before you can begin taking tax-free distributions.

You may be eligible for a 1-time rollover of IRA or unused FSA funds to help fund your HSA.

HDHP premiums are often considerably lower than traditional health plan premiums. The lower premiums can mean you have additional funds to handle the HDHP deductible and fund the HSA.

Employers may fund some or all of the HSA for you.

Employer contributions are tax-exempt.

FSAs

Health FSAs are employer-established benefit plans. These may be offered in conjunction with other employer-provided benefits as part of a cafeteria plan. A health FSA allows employees to be reimbursed for qualified medical expenses, including co-pays, eyeglasses and prescription and over-the-counter medicine. FSAs are usually funded through voluntary salary reduction agreements with your employer.

You may enjoy several benefits from having an FSA.

Contributions made by your employer can be excluded from your gross income.

No employment or federal income taxes are deducted from the contributions.

Withdrawals may be tax-free if you pay qualified medical expenses.

You can withdraw funds from the account to pay qualified medical expenses even if you have not yet placed the funds in the account.

You contribute to your FSA by electing an amount to be withheld from your pay by your employer. At the beginning of the plan year, you must designate how much you want to contribute. Then, your employer will deduct amounts periodically (generally, every payday) in accordance with your annual election. You can change the amount you designate at the beginning of the plan year only if a specified event occurs.

Examples include marriage, divorce, birth or death of a child, loss of coverage under other insurance, and a change in employment status. You aren't taxed on the salary you contribute or the amounts your employer contributes to the FSA. However, contributions made by your employer to provide coverage for long-term care insurance must be included in income. Usually, the amount of money you contribute that isn't spent by the end the plan year is forfeited. In other words, the money is use-or-lose. But some plans contain a provision that allows you an additional 2½ months to use the money. Be sure to base your contribution on a reasonable estimate of the qualifying expenses you expect to have during the year.

Because of the tax savings, an FSA may be advantageous even if you have a small amount of money you'll have to forfeit. You must provide the health FSA with a written statement from an independent third party stating that the medical expense has been incurred and the amount of the expense. You must also provide a written statement that the expense has not been paid or reimbursed under any other health plan coverage.

Dependent Care FSAs

FSAs can also be established to pay for dependent (usually child) care. The amount you can set aside for dependent care generally is limited to $5,000 a year. Although you receive a tax advantage with a health FSAs, dependent care FSAs are a tradeoff between pre-tax deductions and tax credits, such as the Child Care Credit. Generally, the higher your income, the lower the Child Care Credit you'll receive due to income phaseouts. Check with your tax professional to see which is more beneficial to your situation.