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Health Savings Accounts (HSAs) are a valuable tool for eligible individuals to save tax-free dollars for health care expenses, with the added benefit of accumulating tax-free interest over time. Introduced in 2003 and available to individuals starting in 2004, HSAs have become an integral part of health care planning and financial savings.
 
While many health insurance professionals are familiar with HSAs, it can be easy to lose sight of some key mechanics and principles over time. This knowledge is crucial, as HSAs can significantly offset the costs of medical care, create a dedicated savings account for both medical and non-medical expenses (with a tax penalty for the latter, similar to 401(k) withdrawals for non-retirement purposes), and provide one of the few opportunities to earn interest in a savings account tax-free.
 
HSAs offer the unique advantage of tax-free withdrawals when funds are used for qualified medical expenses occurring any time after the HSA's opening, making them a powerful financial tool for managing health care costs. Savvy HSA users often treat their accounts as long-term savings vehicles – maximizing contributions and allowing funds to grow tax-free while paying out-of-pocket for current medical expenses and saving receipts for future tax-free reimbursements, thereby maximizing their savings potential. Likewise, individuals with high plan utilization and higher-than-expected costs can use HSAs to pay coinsurance and deductibles with tax-free dollars, ultimately decreasing their overall cost of care.
 
High Deductible Health Plans (HDHPs)
To establish and contribute to a Health Savings Account (HSA), the accountholder must be covered by an HSA-eligible High Deductible Health Plan (HDHP). These plans typically feature high deductibles that must be met before the plan’s benefits begin to pay. Most HDHPs are HSA-eligible. The IRS annually defines which plans qualify as HDHPs according to certain standards related to the plan’s minimum deductible and out-of-pocket maximum limits.
 
For a 2024 plan to be considered an HDHP, the IRS mandates a minimum deductible of $1,600 for an individual or $3,200 for a family. Although there is no maximum deductible specified, the IRS limits out-of-pocket costs, which include the deductible. For 2024, the maximum HDHP out-of-pocket amount is $8,050 for an individual and $16,100 for a family. As with all PPO plans, the deductible must be paid by the accountholder before the insurance plan starts covering expenses. After meeting the deductible, the accountholder is responsible for paying coinsurance for covered services until the out-of-pocket maximum is reached. Once this maximum is met, the plan typically covers 100% of in-network services for the remainder of the calendar year. PPO plan deductibles and out-of-pocket spending amounts reset annually on January 1st.
 
Due to their high deductibles, HDHP premiums are generally lower than those of other PPO or HMO plans. This is because subscribers pay more out-of-pocket for health care services before the insurance plan starts paying. However, those covered by HDHPs can establish and utilize HSAs to offset these costs with tax savings. (Note that HDHP policyholders are not required to establish or utilize HSAs; they may pay for coinsurance and deductibles like any other PPO plan if they desire.)
 
California’s Legislative Efforts on HSA Taxation
California is one of two states – the other being New Jersey – that currently tax contributions to HSAs. The California Legislature has attempted to pass legislation to exempt Californians’ HSA contributions from state taxes, aligning with federal law, but has not been successful. However, the most recent attempt, SB 230 from the 2023-2024 legislative session, progressed further than any previous effort. The bill started in the Senate and passed, but ultimately died in July 2024, in the Assembly’s Rules and Taxation Committee. Given California’s current budget deficit for 2024-2025 and the projected equivalent deficit for 2025-2026, this outcome was somewhat anticipated. Despite this, the progress made by SB 230 is promising, and Californians remain hopeful for a reintroduction in the future, which could happen as early as January 2025 when the new 2025-2026 legislative year begins.
 
Opening an HSA
Contributions to HSAs can be made up to a maximum amount established annually by the IRS. For 2024, individuals can contribute up to $4,150, and families can contribute up to $8,300. These amounts increase to $4,300 for individuals and $8,550 for families in 2025.
 
To open and contribute to an HSA, a person must be covered by an HDHP. However, once funds are in the HSA, they can be used at any time to pay for current qualified health expenses, such as coinsurance, copayments, over-the-counter remedies, prescription medications, dental costs, and vision costs. Additionally, funds can be used retroactively to reimburse expenses incurred anytime while the HSA was established – though receipts must be retained.
 
Funds in an HSA are contributed with tax-free dollars, grow tax-free, and can be used tax-free for qualified medical expenses. This triple tax advantage makes HSAs a powerful tool for managing health care costs and building savings for future medical needs, including cost-sharing in retirement.
 
HSA Contributions
HSAs can be established by any individual or employee covered by an HDHP. A person covered by an HDHP can establish an HSA at any bank providing the saving option to qualified consumers.
 
Additionally, it is somewhat common for employers with HDHPs to establish HSAs for their employees. Employers can allow employees to make contributions to their HSAs through payroll deduction, utilizing the employer’s Premium Only Plan (POP). Employers can also contribute to their employees’ HSAs; however, the amount contributed by both the employee and the employer may not exceed the annual IRS limits. If the contributions exceed the IRS-established limits, the amount in excess is subject to a 6% excise tax.
 
Individuals aged 55 and older may contribute up to an additional $1,000/year into their HSA accounts, called “catch-up contributions” (ahead of retirement).
 
HSA Distributions
HSAs offer a significant benefit in that distributions for qualified expenses are tax-free. However, the accountholder must follow specific rules to maintain this tax-advantaged status.
 
Qualified Expenses
Qualified medical expenses for HSAs, as defined under Section 213(d) of the Internal Revenue Code, include costs primarily incurred for the prevention or treatment of physical or mental illnesses. These expenses cover a wide range of health care needs, such as doctor visits, hospital stays, prescription medications, over-the-counter drugs, dental and vision care, preventive services costs, mental health treatment, necessary medical equipment and supplies, Medicare premiums, COBRA premiums, and more. Non-qualified expenses, like cosmetic procedures and general health items not prescribed by a doctor, do not qualify for tax-free HSA withdrawals and are subject to taxes and penalties if used inappropriately.
 
Shoebox Rule
The "shoebox rule" allows HSA holders to pay out-of-pocket for medical expenses and save the receipts for future reimbursement from the HSA. This means accountholders can allow HSA funds to grow tax-free while using other funds for immediate medical expenses. When needed, the accountholder can get a reimbursement from the HSA, even years later, as long as receipts are maintained for the qualified expenses incurred after the HSA was established.
 
Self-Adjudication and Self-Policing
HSAs are generally self-adjudicated and self-policed, meaning it is the accountholder's responsibility to ensure that distributions are for qualified medical expenses. While banks and financial institutions that manage HSAs often provide resources and tools to help track expenses and ensure compliance, the ultimate responsibility lies with the HSA holder.
 
Distributions for non-qualified expenses are subject to income tax and, if the accountholder is under 65, an additional 20% penalty. After age 65, distributions for non-qualified expenses are only subject to income tax, like traditional retirement accounts.
 
Responsibilities of HSA Owners
HSA owners have several responsibilities:

• Ensure eligibility: Confirm that the health plan qualifies as a HDHP, and that the accountholder meets all other eligibility criteria.
• Track contributions: Monitor contributions to ensure they do not exceed IRS limits, including contributions made by an employer.
• Recordkeeping: Maintain detailed records for all medical expenses paid from the HSA. This is critical for substantiating tax-free withdrawals and for future reimbursements under the “shoebox rule.”
• Understanding qualifying expenses: The accountholder should become familiar with what constitutes a qualified medical expense.
• Monitor distributions: Make sure that distributions from the HSA are for qualified medical expenses to avoid taxes and penalties.

 
HSA Pros and Cons
Like any financial tool, HSAs come with their own set of advantages and disadvantages. Understanding these pros and cons can help individuals decide whether an HSA is the right choice for their health care and financial planning needs.
 
Pros

• Triple tax advantage: Contributions are tax-deducible or pre-tax if made through payroll deductions. Funds grow tax-free within the account. Withdrawals for qualified medical expenses are tax free.
• Portability: The HSA belongs to the accountholder, not the employer. It remains with the accountholder even when changing jobs or retiring. However, a HDHP must be maintained to contribute to the HSA.
• Long-Term Savings: HSAs can be used to save for future medical expenses, including in retirement. Funds roll over year to year with no expiration, continuing to earn interest.
• Investment opportunities: Once a certain amount of dollars is in the HSA, many accounts allow for investing in mutual funds or other vehicles, potentially increasing the value of the HSA over time.

 
Cons

• High deductible requirement: To open and contribute to an HSA, a person must be enrolled in a HDHP, which often has higher out-of-pocket costs when compared to other health plans.
• Complex rules: The rules regarding contributions, qualified expenses, and penalties can be challenging, requiring careful management and recordkeeping.
• Penalties for non-qualified distributions: Withdrawals for non-qualified expenses are subject to income tax and a 20% penalty if taken before age 65.
• Contribution limits: The annual contribution limits may be lower than what some individuals need to cover their health care expenses, especially for families with significant medical costs.

 
Conclusion
HSAs are a powerful financial tool that offer significant tax advantages, long-term savings potential, and flexibility in managing health care expenses. Whether looking to save on medical costs, invest for the future, or simply take advantage of the triple tax benefits, an HSA can be an invaluable part of one’s financial strategy. With careful management and strategic use, HSAs can be a cornerstone of financial health and security for future and ongoing health expenses.
 
While these are ultimately tax-related matters, it is imperative for employers and employees to obtain legal and/or tax counsel, to ensure full compliance with all applicable laws and tax regulations according to their unique circumstances. This professional guidance will help maximize the benefits of an HSA while avoiding any potential pitfalls.