Health Savings Account (HSA) is a special tax-advantaged savings account similar to a traditional Individual Retirement Account (IRA) but designated for medical expenses. An HSA allows you to pay for current covered health care expenses and save for future qualified medical and retiree health care expenses on a tax-favored basis.

HSAs provide triple-tax advantages: contributions, investment earnings, and qualified distributions all are exempt from federal income tax, FICA (Social Security and Medicare) tax and state income taxes (for most states).

Unused HSA dollars roll over from year to year, making HSAs a convenient and easy way to save and invest for future medical expenses. You own your HSA at all times and can take it with you when you change medical plans, change jobs or retire. This means the funds in the account (both yours and your employer's, if they contribute) are non-forfeitable and portable.

Funds in the account not needed for near term expenses may be invested, providing the opportunity for funds to grow. Investment options include money market accounts, mutual funds, etc.

To be eligible to set up an HSA and to make annual contributions, you must be covered by a qualified High Deductible Health Plan.

Advantages

According to the Treasury Department, HSAs offer several advantages.

Ownership: The money in the HSA---even employer contributions---is yours. There are no "use it or lose it" rules, according to the according to the Treasury Department. Moreover, you get to decide how much to contribute, when to use the money and where to save it.

Tax benefits: Contributions are deductible from your federal income tax, even if you don't itemize. If your employer makes contributions, they are not considered taxable income.

Flexibility: You can use HSA fund to pay for qualified medical expenses or save the money for future needs.

Affordability: High-deductible health plans (or HDHPs) generally have lower premiums than other types of health insurance.

Portability: You can keep your HSA even if you even if lose your job or move to another employer.

Interest: The money in an HSA earns interest.

Disadvantages

HSAs aren't the best option for everyone, and they have several disadvantages.

Higher out-of-pocket medical costs: Treasury Department regulations require you to enroll in a health plan with a high deductible to qualify for an HSA. That means you will have more out-of-pocket responsibility for your health care costs.

Limited use: HSA funds can be used only for qualified medical expenses. They are spelled out in IRS Publication 502.

Penalties: If you use the HSA for something other than qualified health care expenses, those funds are taxable and you face financial penalties, according to the Treasury Department.

Financial risk: If you don't adequately fund the account, your medical expenses could significantly exceed the HSA balance.

Taxes: You must file an income tax return to enjoy all tax benefits of an HSA.

Limitations

The IRS limits how much you can contribute in a given year, and the figure is adjusted annually. For example, the maximum contribution for 2010 is $3,050 for individual coverage and $6,150 for family coverage.

Health Savings Accounts