Even with the Affordable Care Act taking effect last year, health care costs continue to mount. According to a recent study, the average health care premium rate rose 3.3% from 2012 to 2013, while out-of-pocket costs — including co-payments, coinsurance, and deductibles — jumped an alarming 12.8%.1
Depending on the types of plans offered by your employer, you could have access to two types of savings accounts that allow you to make tax-free contributions to help you pay your medical expenses: a health savings account (HSA) and a flexible spending account (FSA).
Health Savings Accounts
A health savings account is a tax-advantaged savings account set up in conjunction with a high-deductible health plan (HDHP). You are eligible for an HSA if you are enrolled in a qualified HDHP, are not covered by another health plan, are not eligible for Medicare benefits, and are not a dependent of another person for tax purposes.
The maximum contribution to an HSA for 2014 is $3,300 for single coverage or $6,550 for family coverage. If you are over age 55, you can contribute an additional $1,000 regardless of whether you have single or family coverage.
Contributions are made via payroll deduction on a before-tax basis, meaning they reduce your taxable income. Note that unlike IRAs and certain other tax-deferred investment vehicles, no income limits apply to HSAs. Any funds not used one year can be saved and used in future years. Earnings on HSAs are not subject to income taxes.
Eligible expenses include most of the out-of-pocket costs not fully covered by your health plan, including co-payments, deductibles, vision care, prescriptions, over-the-counter medicines, dental care, tests, and medical supplies, among others. See IRS Publication 502for a more detailed list of qualifying expenses. If funds are withdrawn for any purposes other than qualifying health care expenses, you will be required to pay taxes on amounts withdrawn plus a 10% penalty.
Flexible Spending Accounts
A flexible spending account (FSA), offered as an elective benefit by many employers, permits you to contribute to an account that is designated for out-of-pocket costs not covered under the plan. All amounts contributed are pretax, and funds are not taxed when spent on qualifying health care costs.
Before contributing to an FSA, you must first designate how much you want to contribute for the year, based on an estimate of your expected out-of-pocket costs. The maximum amount you can contribute to your FSA is $2,500 per year. You do not pay federal income tax or employment taxes on the salary you contribute or on any amounts your employer may contribute to the FSA.
Typically, amounts contributed that are not spent by the end of the plan year are forfeited. However, the IRS recently changed this regulation. If your employer elects to change the restrictions in its plan, you could be allowed to keep up to $500 of your balance to use in the following year. Regardless, it is important not to significantly overestimate the qualifying expenses you expect to incur during the year.
As with an HSA, the eligible expenses for an FSA include most of the out-of-pocket costs not fully covered by your health plan. See IRS Publication 502 for a more detailed list of qualifying expenses.
Which One Is Right for You?
Whether an HSA or FSA will suit your needs depends largely on the out-of-pocket costs you expect to incur and how accurately you can predict them. Ultimately, the decision boils down to your particular circumstances and needs.
1Source: AON Hewitt, AON Hewitt Health Value Initiative Database, October 2013.