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HSA vs FSA: Tax Benefits of Health Savings

While taxes and health care aren’t necessarily on the list of hot cocktail party chatter, they do top the list of many people’s life concerns. The good news is, there are a couple of tax advantages you can use to lower the overall cost of your medical care, by avoiding paying taxes on a predetermined portion of your salary you spend on qualified expenses, such as insurance premiums, copays and other uncovered medical bills and expenses-even transportation. However, this does require planning and some specialized tax knowledge.

The two main options for saving for health care expenses are Flexible Spending Accounts (FSAs) and Health Savings Accounts (HSAs). Both let you allocate pre-tax dollars to pay for anticipated medical expenses. There are limits to how much you can contribute depending on what kind of account you have, so be sure you know these before you start contributing.

Flexible Spending Accounts (FSAs)

FSAs let you set aside before-tax dollars to cover “qualified expenses.” The two most popular types of FSAs cover health care (eligible expenses can include out-of-pocket expenses such as co-pays, insurance deductibles, and certain over-the-counter medications are considered qualified) and transportation, parking, and related travel expenses (essential to receive eligible care).

Each FSA is subject to contribution limits; for health care FSAs, the limit is $2,650 per year. Funding an FSA is done through a salary deferral, which reduces your overall taxable wages. Keep in mind, you lose any money that you don’t use for each contribution year, although some employer plans offer you the option to roll over up to $500 to the next year, which can add up when paying for medical expenses in pre-tax dollars. For example, if you were in the 32% tax bracket and spent $1,000 on medical expenses out of pocket, you’d have to make $1,320 before tax to cover these expenses. However, if you used your FSA, you can allocate $1,000 before tax – thereby receiving an instant tax break.

Health Savings Accounts (HSAs)

If you’re in a high-deductible health plan and you’re not enrolled in Medicare, you can qualify to set up an HSA. You contribute to your HSA with pre-tax dollars that you may draw from tax free to pay for qualified medical expenses.

HSAs offer two main perks: first, the funds may be invested (and grow tax free), and second, they remain in your account from year to year until you use them. There isn’t any “use it or lose it” rule; any remaining balance can be carried over to the following year. In addition, you (not your employer) own your HSA, which means if you change jobs or relocate to another state, you can take your HSA and its balance with you. It is a long-term asset. And after age 65, distributions taken out of an HSA for non-medical expenses are not subject to a penalty (but will be subject to ordinary income tax).

The biggest mistake employees make with their HSA is not funding it enough. If you’re in a high-deductible health plan, it makes sense to open an account since your money is carried forward and accumulates. Your contributions can be invested and withdrawn when you need them for medical expenses. Speak with your employer to find out when open enrollment takes place to open an account. (If you participate in both a FSA and an HSA, make sure you find out how that limits your benefits.)

Our Take

Using tax-advantaged accounts to help pay for health care-related expenses is just one way that you can leverage taxes to your advantage. However, they’re just the tip of the iceberg when it comes to your long-term financial plan. Learn more about taxes and how they fit into your holistic financial life by reading our free guide Personal Capital Tax Guide for Holistic Financial Planning.

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This blog is for informational purposes only; we are not in the business of providing tax or legal advice and we generally recommend seeking the advice and counsel of a tax professional before taking any action that may cause a material taxable event.

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