How does a health savings account work?

Figuring out how to pay for health care is something everyone grapples with. Access to employer-sponsored insurance plans or what you can get in the health insurance marketplace plays a big role in what out-of-pocket costs you'll face. Even with health insurance, you may find yourself coming up short when it comes time to pay medical bills, particularly when you weren't anticipating them.

One way you can prepare for your future is by opening a health savings account alongside your health insurance plan. These accounts don't just encourage you to set aside money—they can provide tax advantages and be a vehicle for retirement savings. It's a flexible and portable option that's worth exploring.

A health savings account, or HSA, is a special spending account where you can deposit pre-tax money for medical expenses. You can spend HSA dollars on qualified medical expenses, which are defined fairly broadly. They include not just doctor and hospital visits but also other products and services, from home health care supplies to certain kinds of therapy.

You don't have to pay income tax on your HSA dollars as long as they're used for qualified expenses, making the money tax-advantaged both going in and coming out. Further, HSA funds can be invested and earn interest through an HSA-providing bank, insurance company or financial institution. That means you can earn returns on those funds that also aren't subject to income tax.

And once you reach age 65, you can take distributions from your HSA account without penalty, though you'll still incur income tax on nonmedical expenses.

One of the main HSA eligibility requirements is to have a qualifying high-deductible health plan that has at least a $1,500 deductible for individuals or $3,000 for families. You'll have the option of contributing up to the current limit per year.

• 2023 contribution limit: $3,850 for an individual and $7,750 for a family
• 2023 catch-up limit for age 55 and older: An additional $1,000

When you deposit money into an HSA, it's typically with untaxed dollars. This might be arranged through a payroll deduction, or you can report how much you contributed to your HSA on your tax return, reducing your taxable income for that year. Just be aware that you'll have to stop contributing in any year that you aren't on an eligible plan. For instance, if you were to enroll in Medicare during retirement, you'd no longer be eligible to make HSA contributions. Regardless of your contributing status, however, you can spend your HSA funds at any time.

Many HSAs use a debit card or checks that allow you to spend from them, similar to a checking account. When you spend on nonmedical expenses, there is a 20% penalty, so always double-check that an expense is qualified. And if you don't end up using all your HSA money within the year, it will just accumulate for you to use in the future.

Once you turn 65, the 20% penalty for spending on nonmedical expenses is lifted, and you can use your HSA money for anything—but note that any nonmedical spending will still likely be subject to income tax.

An HSA is essentially a tax-advantaged account you tuck away to help you cover whatever your health insurance doesn't.

HSA eligibility is only available with certain high-deductible plans that you usually get through your employer or the Health Insurance Marketplace. For many of these, you'll pay more out of your own pocket up-front for the care and procedures you receive until you reach your deductible. Those costs are part of what an HSA can be used for.

Your individual insurance plan will outline what kinds of coverage it offers, including whether you owe coinsurance, copays or some percentage of the cost for a certain kind of care. Many of these costs—other than your actual insurance premiums—also will be qualified HSA expenses.

Putting money in your HSA gives you an account to draw from for those higher up-front costs as well as your copays and any other qualifying medical expenses and incidentals that insurance doesn't stretch to cover.

When you sign up for an HSA-eligible insurance plan, ask your plan provider how to take advantage of the HSA option. In most cases, an employer or a plan provider already will have connected with a bank or credit union where you can create your HSA. They'll show you what's needed to start your account.

At that point, you'll want to decide how frequently you want to deposit money into your HSA. Some employers will help you set up a payroll deduction so that the money goes to the HSA directly. If that option isn't available, the financial institution where the HSA is can help you make deposits. In either case, pay close attention so that you don't deposit more than the amount allowed per year, or you'll risk a penalty.

Once your HSA arrangements are set, make sure you know how the institution handles paying for medical expenses from the account. You may need to order checks, use an HSA debit card or submit receipts for reimbursement. And then, start spending the funds whenever you need medical care or products.

A wide variety of expenses are eligible for HSA spending. Prescription drugs, medical testing supplies and over-the-counter treatments with medicine in them are eligible. So are any consultations with health care professionals, including primary care visits and specialist visits, such as dermatologists, physical therapists and mental health counseling. Treatments like acupuncture and chiropractic are also often covered. And even if your HSA isn't explicitly tied to your vision or dental insurance, you likely can use HSA dollars for checkups, exams, cleanings, surgery, contact lenses and prescription eyeglasses, and more.

Flexible spending accounts, or FSAs, are similar to HSAs but are considered "use it or lose it" accounts. If you don't want the high-deductible plan that HSAs often require for eligibility or simply aren't interested in HSAs for other reasons, FSAs are another way you can save for health expenses. Unlike HSAs—which allow contributions to accumulate long-term, be invested and earn interest tax-free—all FSA dollars have to be spent by the end of the calendar year in most cases.

Some plans do offer grace periods and the ability to carry over money in an FSA, so do your research on your specific FSA vs. HSA options.

The tax advantages an HSA can offer can be valuable for people looking to lower their tax burden. Even if you don't spend up to the HSA limit on medical expenses each year, letting money accumulate in the HSA can be both a safety net for future years with higher medical expenses and a way to earn some tax-advantaged interest or dividends or more if the HSA is able to be invested. HSAs are also portable, which means they stay with you even after a job change. And some people like how the options of a high-deductible health plan coupled with an HSA let them control where their dollars are spent. Plus, employers may offer a benefit where they contribute tax-free dollars to the HSA as well, which is an added incentive.

However, it is also important to keep in mind that HSAs may have a high-deductible requirement, penalties for non-qualified expenses until 65, and may create pressure to save versus spend the money in the account.

Ultimately, every person's health and income situations are unique. A financial advisor can talk through how your particular circumstances match with the appeals of an HSA. This conversation can help you find health discounts and prioritize your goals and values, using your money in ways that work for you over time.