HSA and FSA: Tax-Free Money for Health Care

If you're trying to decide on a health insurance plan at your job, you'll likely see the terms "HSA" and "FSA." HSAs and FSAs are types of accounts that may be available to help you save money on health care expenses and taxes.

Here's how they work.

What Is an HSA?

HSA stands for health savings account. Think of it as a type of savings account for medical expenses. You can only set up an HSA if you also have an insurance plan with a high deductible. A deductible is the amount you have to pay for medical bills before your insurance plan kicks in.

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HSAs aren't just for people who work for companies. If you're self-employed -- and have a high-deductible plan -- you can also set up an HSA.

Some employers may deposit all or a portion of the deductible in an HSA. This money is not considered income, which means you don't have to pay taxes on it. Other employers simply set up the account, and you must make deposits to the account.

Even if your employer contributes to your HSA account, you may contribute extra funds on a tax-free basis, but there is a limit to how much can be contributed. In 2020, total contributions (including yours and your employer’s) -- before paying taxes -- cannot be more than $3,550 a year for an individual. For family coverage, the limit is $7,100.

If you are 55 or older, you can put in an extra $1,000 every year.

You can use the money in an HSA to pay for your annual deductible or other medical expenses such as:

  • Doctor visits
  • Hospital stays
  • Eyeglasses and contacts lenses
  • Chiropractic care
  • Prescription drugs

What Are the Tax Advantages of an HSA?

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Like an IRA or a 401K account, you can keep your HSA even if you switch jobs. Any money you don't use can be rolled over from year to year and invested. If you use any of the money for nonmedical expenses before age 65, you will have to pay a 20% penalty plus taxes on the money you use.

An HSA offers a triple tax break because:

  • Contributions are not considered income so are free from income taxes.
  • You don't have to pay taxes on any increases in the amount of money in the HSA. If you want, you can shift money into mutual funds and other investments after your account balance reaches a certain level.
  • There is no penalty for withdrawing the funds for medical expenses.

What Is an FSA?

FSA stands for flexible spending account. The money that goes into an FSA is tax-free. Generally, you won't pay taxes on anything you spend from an FSA as long as the money is used to pay for qualified medical expenses.

You can use FSA money for medical expenses that aren't covered by your health insurance. For instance, FSA money can be used to pay for:

  • Co-payments and deductibles
  • Prescription drugs or medical devices not covered by insurance plans

Not all employers offer FSAs, and you can't set up an FSA on your own. You also can't set up an FSA if you are self-employed.

When you set up your FSA, you have to let your employer know how much money you're going to put into it for that year. There's a limit to how much money you can put into an FSA. In 2020, the limit is $2,750 for a health care FSA.

There's one important restriction on FSA money. You have to use all the money that goes into it within the year. If you don't, you lose it. The account doesn't roll over into the next tax year.

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