Health savings accounts and flexible spending accounts

Both accounts let you pay medical expenses with pre-tax money. Beyond that they differ substantially, and the differences matter.

Health savings account

Available only to people enrolled in a qualifying high deductible health plan, as defined by IRS criteria on minimum deductible and maximum out-of-pocket amounts.

The tax treatment is unusually favorable. Contributions are deductible or made pre-tax through payroll, growth is tax-free, and withdrawals for qualified medical expenses are tax-free.

Payroll contributions also generally avoid payroll taxes, which adds to the benefit.

Funds roll over indefinitely. Nothing is forfeited at year end.

The account belongs to you, not the employer. It follows you between jobs and into retirement.

It can be invested, once a minimum cash balance is met, in funds offered by the custodian.

After a specified age, withdrawals for non-medical purposes are permitted without penalty, taxed as ordinary income — which makes it function somewhat like a retirement account at that point.

Before that age, non-medical withdrawals face income tax plus a penalty.

The disqualifying coverage rules

You cannot contribute if you have other coverage that is not a qualifying high deductible plan.

This includes a spouse's general purpose flexible spending account, which counts as disqualifying coverage for you.

Enrollment in Medicare ends eligibility to contribute, though existing balances remain usable.

There are specific rules around the months of eligibility and prorated contribution limits, and a last-month rule with a testing period that can trigger tax consequences if eligibility is not maintained.

These details matter and are worth confirming with a tax professional.

Flexible spending account

An employer-established account funded by salary reduction.

Contributions are pre-tax, reducing income and payroll taxes.

Use it or lose it. Funds not used by the end of the plan year are generally forfeited.

Employers may offer one of two relief options: a limited carryover of unused funds to the following year, or a grace period of a couple of months to incur additional expenses. Not both, and neither is required.

The full annual election is available from day one, which is a genuine advantage. You can use the whole amount in January having contributed only one month.

If you leave employment mid-year having used more than you contributed, you generally do not repay the difference.

It does not follow you. Leaving employment generally ends access, subject to continuation options.

Variants worth knowing

Limited purpose flexible spending account, restricted to dental and vision expenses, which does not disqualify health savings account eligibility.

Someone with a high deductible plan can contribute to both an HSA and a limited purpose FSA.

Dependent care flexible spending account, a separate account for childcare and dependent care costs, with its own limits and rules. Not medical.

Health reimbursement arrangement, employer-funded rather than employee-funded, with rules set by the employer.

Qualified medical expenses

Broader than people assume.

Beyond obvious medical care: dental, vision, prescription glasses and contacts, hearing aids, chiropractic care, mental health treatment, physical therapy, certain over-the-counter medications and products, menstrual care products, and many others.

Also qualifying in defined circumstances: certain long-term care premiums, COBRA premiums, and health premiums while receiving unemployment compensation.

Insurance premiums are generally not qualified expenses for HSA purposes except in those specific circumstances.

The definitive list is in IRS publications, which are updated and worth checking.

The receipt strategy

An advanced use of health savings accounts worth understanding.

There is no deadline for reimbursing yourself for a qualified expense, provided the expense was incurred after the account was established.

Which means you can pay medical costs out of pocket, keep the receipts, let the account grow invested for decades, and reimburse yourself tax-free at any point.

The requirement is keeping the documentation indefinitely, which is the practical constraint.

This treats the account as a long-term tax-advantaged investment with an option to withdraw tax-free against accumulated receipts.

Choosing how much to contribute

For a flexible spending account, estimate conservatively, because forfeiture is real.

Base it on predictable expenses: known prescriptions, planned dental work, regular vision costs, expected copays.

Leave unpredictable costs out, since over-electing forfeits money.

For a health savings account, contribute the maximum you can afford, since there is no forfeiture risk and the tax treatment is the most favorable available in the tax code.

Include any employer contribution when calculating against the annual limit.

Catch-up contributions are available above a specified age.

The practical points

Keep every receipt, for both account types. Substantiation is required and audits occur.

Check the custodian's fees and investment options on a health savings account. They vary considerably, and you can generally transfer to a different custodian if the employer's default is poor.

Note that debit cards attached to these accounts can be declined at merchants that do not use the required inventory system, in which case pay out of pocket and submit for reimbursement.

And name a beneficiary on the health savings account, since the treatment on death differs substantially depending on whether the beneficiary is a spouse.

General information about tax-advantaged accounts, not tax, financial or insurance advice. Contribution limits, eligibility rules and qualified expenses change annually. Consult IRS guidance and a qualified tax professional.