Covering medical expenses is one of the biggest financial challenges many Americans face. Not only is our healthcare exorbitantly priced, but even the best health insurance plans don’t cover much of the cost of needed medical care. Arguably, we have access to the best healthcare in the world, but it often comes with a hefty bill. A flexible spending account (FSA) or health savings account (HSA) offers options for reducing the overall burden of medical expenses and making costs easier to manage.
The federal government provides FSAs and HSAs as programs designed to encourage individuals to save for medical expenses that insurance doesn’t cover. You can set aside money for “qualified medical expenses,” such as copayments, monthly prescription costs, and deductibles, and you can take advantage of substantial tax savings. Each program has a similar structure but distinct benefits.
Here’s what you need to know about health savings accounts and flexible spending accounts.
What Is an HSA?
A health savings account is a tax-advantaged plan offered alongside eligible high-deductible health insurance plans, either by an employer or through a private plan. The government determines and sets the minimum deductible amount that qualifies as high-deductible and the maximum dollar amount you can contribute each year.
To qualify for an HSA, the high-deductible plan must be your only health insurance; you cannot be eligible for Medicare or claimed as a dependent by someone else. It’s a portable account, meaning you can take it with you if you change jobs, but you need to be enrolled in a high-deductible health plan to contribute.
With an HSA, the employer or self-employed person will deposit some or all of the deductible into an account to cover costs until the deductible is met. When you meet your deductible, the health insurance policy then kicks in to cover costs directly.
After a health savings account is set up, the employee has the option to contribute additional funds through a payroll deduction from their gross income. Both the money contributed to the account as well as the earnings and interest made on the account balance are tax-free.
When you have an HSA, the funds can be used for a variety of medical expenses, such as prescription drugs, doctor visits, vision, dental, chiropractic, and mental health care. As long as you use the money for qualified expenses, it remains tax-free.
What Is an FSA?
A flexible spending account is similar to an HSA, but you can only have access to an FSA as part of an employer benefits package; you can’t open an FSA as an individual or self-employed person with a private insurance plan.
A popular benefit of an FSA plan is that you can make withdrawals not only for healthcare expenses but also for childcare, allowing significant tax savings for parents with children in daycare.
The money to fund an FSA is deducted from your paycheck pre-tax. You select an amount that you wish to set aside at the beginning of the year and the full amount selected is available to reimburse you for qualified medical expenses, even before you’ve fully funded the account.
This means if you have to come out of pocket for a procedure in January, you can pay the bill, get reimbursed through your FSA, and then continue to fund that amount with payroll deductions throughout the rest of the year. But it’s important to keep in mind that if you leave the employer during the year, you will have to pay back any money you’ve already withdrawn.
What Are the Key Differences Between Them?
Although the plans are similar, you will need to understand the ways in which they are different before you decide which would be most beneficial to you, given the choice.
To be eligible for an HSA, the requirement is that the program is offered in conjunction with a high-deductible health plan (HDHP), whereas an FSA simply needs to be offered as an employee benefit, regardless of health insurance options.
An HSA allows for higher contribution limits, as much as doubling your contributions if you’re covering your family. Contribution limits for flexible spending accounts are considerably lower.
Unlike an FSA, an HSA has the ability to be utilized as a retirement or investment account with the added benefit of funds not being required to be withdrawn at a certain age, like those of 401(k)s or IRAs. It is recommended to speak to a financial professional to see what your options are.
Self-employed individuals can hold HSA accounts, but an FSA can only be held through an employer benefits package.
Your FSA contribution amount must be set during open enrollment and can’t be changed unless you have a change in family status or leave the employer. But you can change your HSA contribution amount at any time during the year.
With an HSA, you can rollover any unused portion of your balance each year, but you forfeit unused FSA funds at the end of the year. Some employers will allow you to roll over up to $500.
If you change your job, you typically lose your FSA unless you are eligible for COBRA continuation; however, HSAs are portable, meaning you can take it with you and continue to contribute as long as you are enrolled in a high-deductible health plan.
HSA contributions are tax-deductible or they may be deducted from your paycheck pre-tax. All growth, interest, and distributions are also tax-free. Contributions are pre-tax for FSAs and distributions are untaxed.
Both options come with benefits that can help you manage your out-of-pocket medical expenses more easily throughout the year. Electing to participate in an FSA or HSA could be a smart financial choice.
How Do I Know Which One, If Any, Is Right for Me?
Determining which program to select and how to take advantage of its benefits requires careful consideration. In most cases, you will not be able to have both at the same time, but there are exceptions to the rule that you would need to discuss with your employer.
As a rule of thumb, an HSA with a high-deductible insurance plan tends to be better for younger healthier people without medical conditions or ongoing prescriptions. These health plans are usually the most inexpensive available, but the tradeoff includes high out-of-pocket limits.
If you are someone with higher medical costs or risks, you are more likely to do better with a health insurance plan that costs more per month but covers more upfront expenses. So a high-deductible plan with an HSA may not be the best option for you. An FSA comes with less flexibility, but it can help you save money alongside any health insurance plan.
The Bottom Line
Health savings accounts and flexible spending accounts are both benefits that allocate pre-tax dollars for health-related expenses. Although structurally similar, they are intended for different purposes and are used differently. While an HSA is used to help defray some of the costs associated with high-deductible health insurance plans, FSAs allow you to use after-tax funds to cover a broader variety of expenses.
John J. Diak, CFP® is the Principal & Client Wealth Manager at Oatley & Diak, LLC in Parker, Colorado. He assists clients through many difficult lifestyle changes such as business downturns, retirement planning, divorce, the death of a spouse, and family estate issues among others. Oatley & Diak, LLC is a family-run registered investment advisory (RIA) firm that provides clients with investment management and financial planning services in a hands-on, intimate environment. Learn more about them at oatleydiak.com.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
This material was prepared by Crystal Marketing Solutions, LLC, and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate and is intended merely for educational purposes, not as advice.