Health savings accounts and flexible spending accounts: How do they compare?

A health savings account (HSA) is a tax-advantaged savings account designed to help individuals with high-deductible health plans (HDHPs) pay for qualified medical expenses. HDHPs typically have lower premiums but higher deductibles, making it essential to have a dedicated savings account to cover out-of-pocket costs.

Key features of an HSA include:

• Tax advantages. Contributions to an HSA are made with pre-tax dollars, reducing your taxable income. Investment earnings within the account are tax-free, and withdrawals for qualified medical expenses are also tax-free.
• Portability. An HSA is owned by the individual, not the employer, allowing you to retain the account and its funds even if you change jobs or retire.
• Investment opportunities. Many HSA providers offer investment options, enabling your contributions to grow tax-free over time.
• Rollover capability. Unused funds in an HSA can be rolled over from year to year, allowing you to build a substantial health care savings reserve.

To open and contribute to an HSA, you must be enrolled in a qualified HDHP. The IRS sets annual contribution limits, which are adjusted annually for inflation. In 2024, the contribution limits were $4,150 for individual coverage and $8,300 for family coverage, with an additional $1,000 catch-up contribution allowed for individuals aged 55 and older.

Contributions to an HSA can be made by you, your employer or a combination of both. Funds within the account can be used to pay for qualified medical expenses, such as deductibles, copayments, coinsurance and other out-of-pocket costs not covered by your HDHP.

Once you reach age 65, you can withdraw funds from your HSA for non-medical expenses without incurring a penalty, although the withdrawals will be subject to income tax. This flexibility makes HSAs a valuable retirement savings vehicle in addition to their primary purpose of covering health care costs.

A flexible spending account (FSA) is an employer-sponsored benefit program that allows you to set aside pre-tax dollars to pay for eligible health care and dependent care expenses. Unlike HSAs, FSAs are funded through voluntary salary contributions made via payroll deductions.

Key features of an FSA include:

• Tax savings. Contributions to an FSA are made with pre-tax dollars, reducing your taxable income and potentially lowering your overall tax liability.
• Eligible expenses. FSAs can cover a wide range of health care expenses, including copays, deductibles, prescription drugs, dental and vision care, and certain over-the-counter medications.
• Use-it-or-lose-it rule. Unused funds in an FSA typically must be forfeited at the end of the plan year or grace period, although some employers may offer a limited carryover option.
• Dependent care FSAs. Separate from health care FSAs, dependent care FSAs allow you to set aside pre-tax dollars to cover eligible expenses related to caring for dependents, such as children or elderly parents.

At the beginning of the plan year, you estimate your anticipated health care and dependent care expenses for the year and elect to have a portion of your pre-tax salary deducted and contributed to your FSA. These contributions are then available for reimbursement as you incur eligible expenses throughout the year.

It's important to note that FSA funds are subject to the "use-it-or-lose-it" rule, which means any unspent funds at the end of the plan year (or grace period, if offered) are forfeited. This emphasizes the importance of carefully estimating your expenses and contributing only the amount you anticipate needing for the year.

Employer contributions to an employee's health savings account (HSA) are generally not taxable income for the employee. This means that both the employer's and the employee's contributions to an HSA are exempt from federal income tax, Social Security tax and Medicare tax.

Specifically, the tax treatment for employer contributions to an HSA is as follows:

• Federal income tax. Employer contributions to an employee's HSA are excluded from the employee's gross income for federal income tax purposes.
• Payroll taxes (Social Security and Medicare). Employer contributions to an employee's HSA are not subject to Social Security or Medicare taxes.
• State income tax. In most states, employer contributions to an employee's HSA are also exempt from state income tax. However, some states may treat these contributions differently, so it's essential to check your state's specific tax laws.

It's important to note that while employer contributions to an HSA are not taxable income for the employee, they are generally considered a tax-deductible expense for the employer. This means that the employer can deduct their HSA contributions as a business expense, reducing their overall tax liability.

While health care flexible spending accounts (FSAs) and health savings accounts (HSAs) have distinct features, they share some fundamental similarities:

• Tax advantages. Both FSAs and HSAs offer tax advantages by allowing contributions to be made with pre-tax dollars, reducing your taxable income.
• Eligible expenses. Both accounts can be used to pay for qualified medical expenses, such as deductibles, copayments, prescription drugs and certain over-the-counter medications.
• Portability (for HSAs). While FSAs are tied to an employer's plan, HSAs are owned by the individual and can be retained even if you change jobs or retire.
• Annual contribution limits. Both FSAs and HSAs have annual contribution limits set by the IRS, which are adjusted periodically for inflation.
• Use for dependents. Funds from both accounts can be used to cover eligible medical expenses for dependents, such as spouses and children.

Despite these similarities, it's important to remember that FSAs and HSAs differ in several key areas, including eligibility requirements, contribution sources, rollover rules and investment opportunities. Carefully evaluating your specific health care needs and financial situation will help you determine which account, or combination of accounts, is best suited for your circumstances.

By understanding the intricacies of health savings accounts and flexible spending accounts, you can make informed decisions that maximize your health care savings while minimizing your tax liability. Whether you opt for an HSA, an FSA or a combination of both, these accounts offer valuable tools for managing your health care costs and achieving financial security in the face of medical expenses.