Health Savings vs. Flexible Spending Account: An Overview
Health savings plans and flexible spending accounts provide two useful options to save money towards your medical expenses while reducing your tax bill. Which account should you participate in to provide the most benefits for you and your family? Let's look at the features of these two popular plans in more detail.
KEY TAKEAWAYS
- Health savings accounts and flexible spending accounts are two benefits offered by some employers that allocate pre-tax dollars towards medical expenses.
- HSAs and FSAs, while structurally similar, are intended for different purposes and must be used accordingly.
- Contributions to HSAs are made with pre-tax dollars, are associated with high-deductible health insurance plans, and can be rolled over each year.
- Contributions to FSAs are also made on a pre-tax basis and cover a wider variety of activities, but you must use it or lose it each year.
Googlawi / Sabrina Jiang
Tackling Rising Healthcare Costs
Healthcare costs make up a huge chunk of most family budgets. One reason: prices for services and health insurance premiums rise every year. U.S. spending on healthcare per capita has increased dramatically in the last five decades, based on analysis from non-profit healthcare research organization KFF. In 1970, healthcare spending per person was $353. In 2022, it was $13,493. Translated into 2022 dollars, the increase was about 7-fold, from $2,072 In 1970 to $13,493 in 2022.
As prices rose, the options for individuals to allocate their healthcare dollars also expanded. In the 1970s, health reimbursement acccounts (HRAs) were created to help offset rising healthcare costs. Flexible spending accounts (FSAs) for medical expenses, part of a major piece of tax legislation in 1978, were intended to help combat some of the drawbacks of the HRA, namely that employees could not contribute to them.
These arrangements were quickly added to a range of pretax employee benefits choices. These plans became known as cafeteria plans because of their similarity to choosing different menu items in a cafeteria. Health savings accounts (HSAs) were created in 2003 so that individuals covered by high-deductible health plans could receive tax-preferred treatment of money saved for medical expenses.
The primary differences between HSAs and FSAs are that an FSA is employer-owned and less flexible; withdrawals are not allowed; and contributions cannot be rolled over to the next year. An HSA is controlled by an individual and is more flexible; withdrawals are allowed with a penalty; and contributions can be rolled over to the next year.
When choosing benefits during open enrollment, it pays to examine the choices carefully. Depending on your situation, a high-deductible health plan paired with an HSA might work well—or it might be too costly. Run the numbers using an online calculator. If you are able to take advantage of a health reimbursement account, an FSA or some of the other choices may be a way to reduce your tax burden.
Health Savings Account (HSA)
An health saving account is offered by employers in conjunction with a high-deductible health plan (HDHP). Self-employed people who have high-deductible plans can also set up HSA accounts.
The employer or self-employed individual deposits all or a portion of their deductible into an HSA to cover costs until the deductible is met and the health insurance policy takes over the financial burden. Anyone can contribute to your FSA, including family members, friends, and your employer.
Once the account is set up, an employee can contribute additional money to the HSA via a payroll deduction from gross income. The money contributed to an HSA account is made with pretax dollars, which reduces the amount of income reported for tax purposes. Interest or earnings on the money in the account is also tax-free.
Many HSAs provide you the option to invest your funds and earn additional money, allowing contributions to grow faster through compound interest. Once you reach age 65, you can basically treat your HSA like a retirement savings plan, as the 20% withdrawal penalty no longer applies after that age.
HSA withdrawals used to pay for qualified medical expenses are tax-free transactions.
Flexible Spending Account (FSA)
A flexible spending account is similar to an HSA, but there are a few key differences. For one, self-employed individuals aren't eligible.
One of the biggest benefits of an FSA is that it can be set up as a Dependent Care FSA (DCFSA) to allow withdrawals for childcare expenses. It is also possible to have a separate, regular FSA to cover medical expenses depending on your company's plan.
Like the HSA, you can contribute to an FSA using your gross pay, making your contributions tax-free. As long as you use the funds to pay for qualified medical expenses, you probably won't owe taxes on withdrawals.
How Do You Qualify for an HSA or FSA?
Self-employed people can open an HSA but not an FSA. To be FSA or HSA eligible, you must meet specific guidelines, as described below.
HSA vs FSA: Key Differences
A withdrawal from an HSA can be used for a broad range of medical expenses such as eyeglasses, contacts, chiropractic care, and prescription drugs, as well as doctor visits and hospital stays. However, an FSA provides earlier access to your funds than an FSA does. HSA funds only accumulate as your make contributions, so you can only take out whatever you have contributed to date. On an FSA, once you select your contribution for the year (such as $2,500), the full amount is available for use on the first day of the plan year.
The HSA is a portable account that allows you to keep your money even if you switch jobs. To qualify for an HSA, you have to be enrolled in a high-deductible health plan. In most cases, you are not eligible if you have other health coverage or can be claimed as a dependent by someone else.
Aside from setting up your FSA as a DCFSA, which allows withdrawals for eligible childcare expenses, you can also have a separate, regular FSA to cover medical expenses depending on your company's plan.
Like the HSA, you can contribute to an FSA using your gross pay, making the contributions tax-free. As long as you use the funds to pay for qualified medical expenses, you probably won't owe taxes on withdrawals.
The table below shows the differences and similarities between both health accounts:
Other FSA Considerations
Unlike an HSA, you have to declare how much you would like your employer to deduct from your gross pay to fund your FSA in each calendar year. Once that declaration is made, you generally can't change it.
If you declined the FSA during the open enrollment period, you'll likely have to wait until the next open enrollment.
Your declared FSA funds must be spent within the tax year, although a grace period is sometimes granted. The money you contribute can be lost if you don't spend it all by the deadline.
You don't have to be covered under a health insurance policy to be eligible, but FSA funds are not an adequate substitute for health insurance. You also can't use an FSA to pay for your health insurance premiums. If you can't afford both, it would be better to put those funds toward health insurance.
The Bottom Line
If you meet the eligibility requirements, an HSA is typically a better choice for most people, because you can contribute a higher amount and any unused funds roll over to the following year. If you are enrolled in a high-deductible health plan that meets the rules of eligibility established by the IRS, you are free to enroll in an HSA either through your employer or on your own.
Still, many companies offer both HSA and FSA plans. Under certain conditions, you may be able to sign up for both. In either case, establishing a medical savings plan can represent significant annual tax savings depending on your tax bracket. If you establish an FSA, just keep an eye on the account to make sure you don't let any accrued money expire at the end of the year.
The eligibility requirements, allowable contributions, and rules for medical savings plans are established by the IRS. You can reference these details in IRS publication 969.
- Health Savings vs. Flexible Spending Account: What's the Difference? CURRENT ARTICLE
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- Health Savings Account (HSA) Definition
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