How a health savings account (HSA) works

Health savings accounts: What you don't spend on medical expenses stays in your tax-advantaged savings account and continues to grow.

Does the rising cost of health insurance make you sick? Nauseated by your policy’s limited choices of doctors and drugs? Feverish because Medicare is foundering along with your pension, turning your much-anticipated retirement into a looming nightmare?

A health savings account (HSA) could be just what the doctor ordered. Used wisely, this innovative approach to health coverage may provide major advantages that could keep both your personal and financial life healthy.

A health savings account is a tax-advantaged personal savings account that works in combination with a high-deductible health insurance policy (HDHP) to provide both an investment and health coverage. The savings account provides the funds you use to pay medical expenses or  – if you don’t need to use it – is an interest-bearing nest egg that grows until you retire. The HDHP, meanwhile, is your safety net should you need catastrophic coverage for major medical expenses.

how an hsa works

Opening an HSA account allows you to pay lower federal income taxes by making tax-free deposits into your account each year up to $3,050 for individuals or $6,150 for family coverage, even if you take the standard deduction and don’t itemize. (If you’re 55 or older, you can contribute an extra $1,000 a year.) Most states also offer tax breaks on funds deposited in these accounts.

The money you deposit into your HSA account is yours to withdraw at any time to pay for medical expenses that aren’t covered by your high-deductible individual health insurance policy. HSAs are considered part of consumer-driven health care (CDHC), meaning that you control the plan, deciding how to spend and invest those dollars.

Expenses may include deductibles, copayments, prescription drugs, vision and dental care, and other out-of-pocket medical costs. And the range of services that qualify is broad: You can use your HSA to pay for acupuncture, chiropractor services, aromatherapy or even traditional Chinese medicine. (Starting in 2011, however, you can not use tax-advantaged money from an HSA for over-the-counter drugs that are not prescribed by a doctor.)

In fact, you can use the account to pay for the medical expenses of a spouse or other family member – meaning you can cover same-sex and domestic partners – even if they aren’t covered by your HDHP.

If you’re fortunate enough to not need to withdraw from the account to pay for medical expenses, your funds roll over from year to year and your account continues to grow. When you reach age 65, you’re allowed to draw from any unspent HSA funds. You can still spend the funds tax-free for medical expenses, or you can withdraw them without penalty (though you will pay income tax on the withdrawals).

Sounds too good to be true? Well, remember that you’re paying a lower premium for your insurance coverage because it’s a high-deductible plan, and before your catastrophic coverage kicks in, you’ll need to pay that high deductible. IRS-qualified plans have deductibles between $1,200 and $5,950 for singles, and $2,400 and $11,900 for families.

health savings accounts get mixed reviews

The country is largely split over the question of whether health savings accounts are a wise coverage solution on a large scale – and whether HSAs help or hurt the nation’s health care system.

Proponents of HSAs argue that people tend to be more careful with their own health care costs when they’re paying part of the bills themselves. So instead of going to a doctor for every cough, cut or cramp, HSA users would have an incentive to be less wasteful with their health care spending, and maybe even take the time to shop around.

They say that the cumulative effect will be a nation of health consumers whose behavior would lower health care costs, while injecting price and quality competition into the medical marketplace. And tax advantages, they say, could lure the uninsured into lower-cost, high-deductible plans, reducing the ranks of the uninsured and possibly even nudging them into healthier lifestyles.

Critics of HSAs argue that health savings accounts benefit the young and healthy, while those with regular medical problems or who are older may end up paying more because they tend to drain their savings with more frequent up-front medical expenses. Critics also argue that the accounts destabilize the health insurance marketplace by removing the healthy from the insurance pool, thus driving up premiums for those remaining.

Another argument is that the tax-advantaged option constitutes a tax shelter for the rich, and that low-income families don’t earn enough to benefit from the tax breaks. Further, skeptics warn that many people with HSA plans – and especially the poor – might be reluctant to spend money from their savings account for preventive and routine services, which could lead to higher-cost problems later.

accounts are becoming mainstream

Politics aside, more than 10 million consumers today have HSAs, according to a survey done last year by America’s Health Insurance Plans (AHIP). That’s up from 8 million in 2009 and 6.1 million in 2008.

Many businesses, large and small, offer these HDHP policies to their employees, but you can also purchase them on your own through banks, insurance companies, credit unions, mutual funds or qualifying brokerages.

“We have seen the popularity of HSAs skyrocket with employers and consumers in 2010 and entering 2011,” said Kirk Hoewisch, president of HSA Bank, where HSA deposits – from individuals to Fortune 500 firms – have doubled in the past three years to more than $1 billion.

If you do decide to try HSAs, be sure to shop around before setting up your plan. The good news is that interest rates on health savings accounts – because they are investments – are higher than traditional bank savings accounts.

But the saving accounts include a dizzying array of options. Brokerages offer countless stocks, bonds and funds to invest in with low trading fees, while others may have limited choices, are more expensive, and have hidden fees.

Tags: health savings account, hsa, individual health insurance, medical expenses