When you think about your employer’s healthcare benefit options, you may wonder whether it’s better to contribute to a health savings account (HSA) or a flexible spending account (FSA). The following discussion will help you answer that question by describing the basic characteristics of an HSA and an FSA, and the differences between these two healthcare savings accounts. You also will learn a few strategies for figuring out which is best for your personal situation.
What is a Health Savings Account?
In 2003, federal legislation was signed into law creating the Health Savings Account (HSA) for people covered by high deductible health plans. The law’s intent is to help people covered by high deductible plans save money to pay their future qualified medical expenses until their health plan starts paying benefits. You and your employer may both contribute to your HSA, but you own it.
The Internal Revenue Service (IRS) rules determine what qualifies as medical expenses. In the wake of COVID-19, the IRS issued guidance that the agency considers expenses related to at-home COVID-19 tests, hand sanitizers, and Personal Protection Equipment (PPE) as qualified medical expenses under HSAs.
The HSA rules do not permit you to qualify for an HSA if you are:
- A dependent on anybody else’s tax return;
- Have other health coverage that pays from the first dollar; or
- On Medicare.
Many young people today select high deductible health plans sponsored by their employer. High deductible plans are popular because they have lower premiums than lower deductible plans. As you might expect, however, that high deductible may become a drawback if you have unexpected medical expenses. Those medical expenses will come out of your pocket until your expenses meet the plan’s high deductible.
The minimum deductible in 2022 for an HSA is $1,400 for an individual and $2,800 for a family. The maximum you will pay out-of-pocket for medical expenses under your HSA is $7,050 for self-only coverage in 2022, and $14,100 for family coverage.
A Tax-free Savings Account
IRS treats the contributions you make to the HSA as tax-free. That means that the government imposes no taxes on the:
- Contributions you and your employer make to the HSA,
- Earnings on those contributions, or
- Payments from the HSA when you pay for covered expenses.
Perhaps the most popular aspect of the HSA is that you have a nonforfeitable right to your contributions. That means if you have any contributions unused at the end of the year, you may roll them over to the next year. You do not lose them.
If you change jobs, you retain the funds in your HSA. Also, you may make arrangements to transfer, upon your death, the HSA tax-free to your surviving spouse.
Annual Limitations on HSA Contributions
The law places limitations on the amount of contributions you may make to an HSA each year. This limitation threshold changes periodically. In 2022, the maximum contribution threshold for an individual is $3,650. For a family, the law limits contributions in 2022 to $7,300. Those maximum contribution limits apply to the total contributions made by you plus any contributions your employer makes to your HSA. One wrinkle in the law permits individuals over age 55 to make up to $1,000 in additional “catch-up contributions”.
You do not want to make contributions that exceed the annual maximums. If you do, you will incur a 6% tax on those excess contributions. In addition, excess contributions are not tax-deductible.
Penalties for Non-covered Expenses?
If you use your HSA contributions to pay for non-qualified expenses, you will incur a 20% penalty plus the IRS will impose income tax on the contributions. The 20% penalty goes away after you reach age 65, but income tax still applies to contributions used for non-qualified expenses.
HSA Investment Opportunities
Since you cannot lose your contributions (that is, they are nonforfeitable), you have the opportunity to invest those contributions to earn additional income. You may invest in both stocks and securities.
What is a Flexible Spending Account?
You may recognize a flexible spending account, or arrangement, by its more popular acronym, FSA. An FSA is a kind of savings account that your employer offers to its employees. When you participate in an FSA, you contribute some of your wages to the account on a pre-tax basis. That means that your contributions to the FSA may lower your tax liability for that year. The funds withdrawn for qualified expenses are tax-free, too.
What’s a Medical Expense FSA?
There are basically two types of FSA: the medical or healthcare expense FSA, and the dependent care FSA.
Under the medical expense FSA, you may use FSA funds to pay for specific non-covered healthcare expenses for you, your spouse, or your dependents. It does not matter what medical plan covers your spouse or dependents; however, dependents qualify only if they are listed as a dependent on your tax return. They are not dependents if they file individual tax returns.
Qualifying healthcare expenses include:
- Vision care,
- Dental care,
- Medical equipment,
- Diagnosis and treatment of medical conditions,
- At-home COVID-19 tests,
- Hand sanitizers,
- PPE, such as masks, and
- Plan deductibles and co-payments.
Expenses for cosmetic treatments or spa memberships are not qualifying expenses.
What’s a Dependent Care FSA?
Funds contributed to a dependent care FSA may pay for childcare expenses for qualifying dependents under age 13. Under the IRS rules, you may also use funds in a dependent care FSA to pay for expenses related to an adult who cannot take care of themselves.
The dependent care FSA can save you thousands of dollars in both federal income tax and FICA employment taxes. Your savings will depend on your income tax bracket and how much you pay for childcare.
Annual FSA Contribution Limits
Naturally, the IRS limits the amount of FSA contributions you may make each year. For 2022, the maximum threshold for your medical expense FSA is $2,850. For married employees, your spouse may also contribute up to the annual limit. In addition, your employer may make tax-free contributions to your FSA on your behalf. Employer contributions do not count against your annual maximum limitation.
The maximum threshold for contributions to a dependent care FSA for 2022 is $5,000 if you file as a single taxpayer or married filing jointly. If married, but you file separately, the limitation is $2,500.
The snag with an FSA is that you must use the funds contributed by the end of the plan year, or by March 15th of the following year. If you do not use the funds by plan year-end, they revert to the employer. Since employees may forfeit unused FSA contributions, it is important to estimate accurately how much you contribute each year. Employers may also permit rollovers up to $550 of unused FSA contributions toward the next year’s expenses. Employers do not have to offer either the March 15th grace period or the $550 rollover.
Please note: You may not invest your FSA funds because you make contributions on a use-it-or-lose-it basis.
What Is an HSA Limited-Purpose FSA?
There is a third-type of FSA created for the limited purpose of coordinating with an HSA. This is the only type of FSA that employees may use if they have an HSA.
Contributions to a Limited Purpose FSA, or LPFSA, are pre-tax contributions. You may use the funds in an LPFSA to pay for dental or vision expenses. The LPFSA funds may also pay specific IRS defined covered expenses under the HSA after the employee satisfies the HSA’s high deductible.
What Is the Best Option for Me?
Only you can decide whether an HSA or FSA is best for you. Here are a few things to remember when deciding whether you are better off with an HSA or an FSA.
You most likely prefer an HSA if you:
- Have a high deductible medical plan that meets the required out-of-pocket maximum threshold each year;
- Have no other healthcare coverage that pays first dollar coverage;
- Have enough discretionary cashflow to fund the HSA as needed;
- Want to invest your contributions for increased savings; and
- Want a supplemental retirement savings vehicle that, after age 65, allows you to withdraw your HSA contributions tax-free without paying for medical or healthcare expenses.
You most likely prefer an FSA if you:
- Have healthcare coverage without a high deductible;
- Have recurring health expenses not covered by the underlying health insurance;
- Need access to the entire FSA amount for medical, dental, or vision expenses while you make periodic contributions;
- Pay childcare expenses for dependents under age 13; and
- Want to pay for covered expenses on a pre-tax basis which reduces your annual tax liability.