A Tax Tip from The Tax Institute at H&R Block

What is a health savings account?
A health savings account, or HSA, is a tax-advantaged savings account used to pay for out-of-pocket medical expenses. “Tax-advantaged” means:

• Contributions to your HSA account are either tax-deductible (similar to deductible IRA contributions) or made pre-tax if the HSA is offered through an employer’s cafeteria plan (similar to 401(k) contributions). 
• Earnings in the account are not taxed.  
• Distributions from the account that are used to pay for qualified medical expenses are tax-free.

What is a high deductible health plan?
Most tax-advantaged savings vehicles have only one or two of these features, but HSAs have all three. But there is a catch. In order to be eligible to contribute to an HSA, you must have a particular type of medical insurance called a high-deductible health plan, or HDHP. As the name implies, an HDHP:

• Must have a high deductible; for 2010 the minimum deductibles are $1,150 for self-only HDHP coverage and $2,300 for family coverage. 
• And an HDHP must not pay medical benefits until the deductible is satisfied. For example, a medical plan that pays for prescription drugs or office visits without regard to the deductible is not a qualifying HDHP. There are, however, exceptions for preventative or “wellness” benefits, such as basic health check-ups, maintenance drugs, cancer screenings, etc.

Other eligibility requirements of an HSA
There are some other eligibility requirements. You must not be a dependent on another person’s return, you may not have any other type of health insurance coverage (including coverage on your spouse’s non-HDHP plan), and you may not be enrolled in Medicare. Here is another exception: certain “permitted coverage” is allowed, including dental, vision, and long-term care insurance. There is no earned income requirement.

If you meet all of the requirements, you may contribute up to $3,000 ($5,950 if you have family HDHP coverage) to your HSA. If you are at least age 55 by December 31, 2009, you may contribute an additional $1,000 catch-up contribution.

You may use your HSA funds tax-free to pay for out-of-pocket medical expenses including doctor’s visits, prescriptions and over-the-counter medicines, laboratory tests, hospital stays, etc. However, if you use HSA funds for some other purpose, the distribution is subject to tax at ordinary rates and, if you are under 65, a 10% penalty.

So who benefits from an HSA?
The HDHP requirement can be daunting and, for that reason, the HSA/HDHP combination is not for everybody. If you are healthy and have relatively few medical costs you will clearly benefit from participation in an HSA. However, even if your medical needs are high, compare the HDHP deductible and out-of-pocket costs with the HDHP premium savings, as well as the HSA tax savings—and you may be pleasantly surprised. 

Consider all of these advantages in addition to the tax advantages:

• HSA funds are not “use or lose,” unlike flexible spending accounts (FSAs). You may keep the funds in the account as long as you wish and use them only when you need to.
• And, unlike Roth IRAs, there is no waiting period before you can begin taking tax-free distributions.
• HSA funds may be used to pay qualified expenses for yourself, your spouse, and your dependents—even if you have self-only HDHP coverage.
• You may be eligible for a one-time rollover of IRA or unused FSA funds to help fund your HSA.
• If you are no longer eligible to contribute to your HSA (perhaps because you’ve changed your medical plan), you may still keep the HSA and use it as you need to.
• HDHP premiums are often considerably lower than traditional health plan premiums. The lower premiums can mean you have additional funds to handle the HDHP deductible and fund the HSA.
• Employers may fund some or all of the HSA for you. Employer contributions are tax-exempt.

With all of its features, in addition to meeting your medical expense needs, if you are consistently able to contribute to your account an HSA can be a valuable part of your retirement and estate planning goals. 

This Tax Tip Article is brought to you by The Tax Institute at H&R Block.

To view other helpful tax tip information, visit the H&R Block Community, Digits, at www.digits.hrblock.com

As always...everyone's tax situation is different, so be sure to consult a tax professional or financial advisor before making important financial decisions.

This Tax Tip Article is for educational purposes only and is not intended to be a substitute for seeking personalized, professional advice, nor is it intended to be used to avoid IRS penalties.