The Tax Benefits of Health Savings Accounts (HSAs)

The HSA Tax Deduction

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Health savings accounts (HSAs) are tax-deductible savings plans that allow you to put aside pre-tax dollars for future health care expenses. Pre-tax dollars are subtracted from your pay before taxes are withheld, so you don't pay tax on this portion of your income. 

According to the Internal Revenue Service (IRS), an HSA is a tax-exempt custodial or trust account that's set up with a trustee. Distributions aren't taxed as long as you use the money to pay for qualified medical expenses.

Qualifying Rules

Eligibility rules require that you must be enrolled in a high-deductible health insurance plan to qualify for an HSA. You can't be covered by a plan such as an HMO or a PPO-type plan.

The high-deductible plan must meet certain requirements. The minimum annual deductible limit for 2021 is $1,400 for self-only coverage, or $2,800 for family coverage.

There are no income limitations to qualify for a health savings account. Individual retirement accounts (IRAs) require that a person must have earned income, but there's no such requirement for HSAs.

Limitations on Contributions

There's a cap on how much you can contribute and save each year. This amount can increase annually, although it doesn't necessarily do so. Contribution limits are $3,600 for self-only HSAs in 2021, or $7,200 for family HSAs. Contributions made by your employer count toward these limits.

Those who are age 55 or older can contribute an additional $1,000. This "catch-up" contribution isn't indexed for inflation, so it's the same amount from year to year. You can make this additional contribution at any time during the year.

You aren't permitted to make HSA if you're enrolled in Medicare.

How Contributions Are Treated 

Contributions to an HSA are tax-deductible on your Form 1040 tax return as an adjustment to income. You don't have to take them as an itemized deduction for medical expenses, which is advantageous because itemized medical deductions are limited to expenses paid in excess of 7.5% of your adjusted gross income through 2020. This threshold is slated to increase to 10% in 2021.

The IRS indicates that contributions to your HSA made by your employer can be excluded from your gross income, but you also can't claim a tax deduction for them.

Contributions for a particular tax year are due by the same day as the filing deadline for your tax return, which is usually April 15 unless this date falls on a weekend or a holiday. The deadline is the next business day in this case.

Earnings Are Tax-Exempt 

Earnings, such as interest and dividends from the money contributed to an HSA, are tax-exempt at the federal level. Interest or other investment income earned on the contributions are not included on your tax return.

Withdrawing From Your HSA 

Withdrawals from an HSA are tax-free as long you use the money to pay for qualified medical expenses. "Qualified" expenses are detailed in IRS Publication 502, Medical and Dental Expensesand they include most medical costs, from birth control pills to guide dogs to surgery.

They also include mileage traveling to and from treatment, but not costs associated with items that are just considered "healthy," like vitamins or gym memberships. They include costs incurred on behalf of yourself, as well as your spouse and dependents.

Using an HSA as a Tax-Planning Tool 

HSAs accumulate earnings and income without being subject to forfeiture the way flexible spending accounts are if they're not used. Money held inside an HSA can be withdrawn at any time for qualified medical expenses, so an HSA can be used to accumulate tax-free income for use later in life. You can build tax-free savings for future medical expenses as you age.

HSAs additionally offer people with few medical expenses a tax deduction upfront in the year that contributions are made.

How to Claim the Deduction

Financial institutions report HSA contributions on IRS Form 5498-SA, which is sent to both the taxpayer and to the IRS. You can then report your tax-deductible HSA contributions on Form 8889, with the total contributions transferred to and reported on your Form 1040.