Category Archives: HSA Benefits

HSA vs. FSA – How to choose between a Health Savings Account and a Flexible Spending Account

HSA vs FSA: which is better?

The age old debate – which should I use, a Health Savings Account or a Flexible Spending Account? Maybe both? Each person’s health care situation is different with different needs and objectives. The goal of this article is to educate you on the similarities and differences so that you can choose the plan that makes sense for you and your family. But the name of this site may provide a hint as to which (I feel) is superior.

Flexible Spending Account defined

A Flexible Spending Account (technically, Arrangement) or FSA is an employer established benefit plan that allows employee and employer contributions to a tax advantaged account to offset the cost of medical expenses. Contributions and distributions to/from the account are tax deductible if they are used for qualified medical expenses. FSA monies generally expire at the end of the year, sometimes with a 3 month grace period or maximum amount ($500) allowed to be rolled over.

Health Savings Account defined

A Health Savings Account or HSA is a tax advantaged account managed and owned by the individual used for medical expenses. Only individuals with certain types of insurance (High Deductible Health Plans, or HDHP’s) are allowed to open HSA’s. Monies contributed to, or distributed from, HSA’s are tax deductible if they are used for qualified medical expenses and have advantages if saved for retirement. HSA funds are owned by the individual, can be invested, and remain theirs forever.

Differences between HSA and FSA

While they sound similar, there are subtle differences between Health Savings Accounts and Flexible Spending Accounts and how they operate.

	FSA	HSA
Established by	Employer	Employer or Individual
Insurance Required?	No	Yes
Type of Insurance?	Any or none	HDHP only
Managed by	Employer	HSA holder
Contribution Amount	Determined at enrollment	Determined during year
Contribution available	Immediately	As contributions occur
Contribution method	Deducted from paycheck	Deducted from paycheck or contributed post tax
Contribution Limit	$2,550	$3,400 / $6,650 (single / family)
55+ Contribution Amount	none	$1,000
Ideal Contribution	Amount you will spend that year	max Contribution Limit
Unused Contributions	Expire at year end	Yours forever
Invest Contributions	No	Yes
Prior Year Contribution	No	Yes
Employee leaves job	Unspent contributions lost	Takes HSA with them
Self Employed	Ineligible	Eligible
Tax reporting	none	IRS Form 8889
Retirement benefits	none	many

As you can see, the list is long and there are some key differences there. Overall, HSA’s appear more flexible and offer more options for how you manage those contributions long term.

Similarities of both HSA’s and FSA’s

Being government sponsored and tax friendly accounts, both Health Savings Accounts and Flexible Spending Accounts share some similarities in how they operate.

	FSA	HSA
Employee Contributions	Yes, optional	Yes, optional
Employee Contributions	Yes	Yes
Payroll Contributions	Yes	Yes (optional)
Tax Deductible	Yes, if spent on Qualified Medical Expenses	Yes, if spent on Qualified Medical Expenses
Can be spent on	Qualified Medical Expenses per IRS 502	Qualified Medical Expenses per IRS 502

Advantages of HSA over FSA

There are many advantages of a Health Savings Account over Flexible Spending Accounts, and I believe it to be the better plan all things considered. The biggest one is that HSA contributions are yours forever, no matter if you change jobs, change insurance, get fired, get old, retire, or what have you. They are yours to keep and can be spent on qualified medical expenses in a tax free manner at any time (or year) your wish. That is huge because you worked hard for that money, you shouldn’t forfeit it because the year changed. The fact that HSA contributions remain yours have other benefits, too. It provides flexibility to spend them as you need them, not try to cram all of your spending into the given year. You can save them for a rainy day, and even invest and grow your HSA. Once you turn 65, your HSA can be spent on whatever you want without penalty (you just pay tax on it, which you would have paid anyway). Hopefully at that point, your tax rate is low and and your HSA has grown for many years tax free. In this way, it is similar to a 401(k) or IRA investment account

Advantages of FSA over HSA

Notice in the “Differences” chart that the Contribution Available row for FSA says “Immediately”. That is because employers actually make the full year’s FSA contribution at the beginning of the year, and you pay them back every paycheck throughout the year. So for example, if you elect to contribute $24 to your FSA, on January 1st the employer puts $24 in your FSA. That money is immediately available and you can go out that day and spend $24 on a copay (for example). The advantage is the employee gradually “pays back” the contribution through the year, which smooths the contribution and doesn’t take so much out of pocket. So in each bimonthly paycheck that year you pay back $1, which is a huge cash flow advantage.

This advantage can (perhaps nefariously) be taken a step farther. With an FSA program, employers take on the risk of gain or loss with each employee’s FSA account since they make the full year contribution at the beginning of the year. This is because employees can leave or be terminated throughout the year. This occurs because 1) employees are not required to pay back spent but not contributed FSA amounts, and 2) employees do not receive FSA benefits that are contributed but not spent. This is best illustrated with some examples:

1) Employee wins

Let’s assume that John signs up for an FSA and contributes the full amount for 2015, $2,550. This amount goes into his account immediately at the beginning of the year, so on January 1st his employer contributes $2,550 to John’s FSA. Per the FSA, John agrees to contribute $2,550 over the course of the year, so John will have $106.25 deducted from each bimonthly paycheck. Let’s say on January 4th John has a surgery and uses his full FSA to pay for it. His account is now at $0, he has spent $2,550 and has contributed $0. On January 7th, John gets an offer from BigCorp and decides to leave his FSA employer. Guess what – John does not owe back the FSA amount of $2,550. Employees are not responsible for making up FSA amounts spent but not contributed You read that right, as John gets away free and the employer takes it on the chin.

2) Employer wins

However, the reverse is also true. Assume Paul elects to contribute the full amount of $2,550 to his FSA for 2015. Paul is healthy and doesn’t spend anything through December, and has diligently contributed $106.25 from each paycheck. He has an FSA with $2,550 available to spend and has personally contributed something like $2,444 as of December 15th. The next day, his company BigCorp lays off John unceremoniously just before the holidays. Unfortunately, John is given no warning and cannot spend the $2,550 in his account. This amount will expire when he is terminated and all of that money he contributed is lost. Ironically, the employer recognizes this unearned money as a gain.

Choosing between an HSA and FSA

As you can see above, there are many factors that apply to Health Savings Accounts and Flexible Spending Arrangements. Some of those may apply to your situation, and some may not. You will probably give some factors different weight in your decision than I do in mine. That said, here are some general guidelines in choosing between an HSA and FSA. [Note that you generally cannot contribute to both an HSA and FSA in the same year unless your FSA is a limited-purpose, or HSA compatible, FSA].

All things equal, choose the HSA. You will thank me later.
If there is money on the table, that should weigh heavily. If your employer is generous enough to contribute to a program free of charge to you, that is probably a good choice to make.
Choose an HSA if your spending is long term. If you are considering contributing amounts close to the max of either plan, the HSA will allow you to keep those amounts and roll them over year over year.
If your only option is FSA, choose it, but contribute wisely. You definitely still want a tax advantaged plan for your medical spending, and an FSA will do this. However, be very cautious over contributing to an FSA as you will lose that money at year end (or be forced to buy a bunch of stuff you don’t really need).

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Note: if you do go with an HSA, please consider using my service TrackHSA.com to manage your Health Savings Account. You can store purchases, receipts, and reimbursements securely online.

Can You Cash Out an HSA?

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After saving diligently, using either individual or employer contributions, you may want to take your money out of your Health Savings Account and use it for something different. Before you go to the ATM or HSA website and withdraw all of your HSA funds, take heed: there may be tax consequences to improperly withdrawing money. Let’s discuss the implications and options.

Part of the advantage of an HSA is that the money is triple tax advantaged – you are able to save significantly on taxes by contributing to the HSA. The catch is, this money is required to be used for qualified medical expenses. As such, the government does not look fondly at taking a tax advantage and then not playing by the rules.

Nevertheless, let’s discuss 4 options for removing money from an HSA account:

1) Non Qualified Withdrawal (Penalty Tax)

This is the hard way, just rip the money out and pay the price. From the IRS HSA page:

You can receive tax-free distributions from your HSA to pay or be reimbursed for qualified medical expenses you incur after you establish the HSA. If you receive distributions for other reasons, the amount you withdraw will be subject to income tax and may be subject to an additional 20% tax.

Yes, that 20% tax sure bites, as it was your money to begin with but it is stuck in a “special” government account. That said, this is always an option. When you file your IRS Form 8899, you will have to call out this amount on Line 16 as a taxable distribution. This amount will be added as income on Form 1040 (i.e. you will then pay tax on it), plus Line 17b will assess a 20% penalty that flows over to Form 1040. An expensive option, but at least you can get the funds out of the HSA.

2) Use for Qualified Medical Expenses

This is the right way to remove funds from an HSA account, paying for (or reimbursing) qualified medical expenses. Assume you have a doctor appointment that you pay for out of pocket using a credit card, debit card, or cash. Since this is a qualified medical expense, you are immediately entitled to reimburse yourself for that expense out of your HSA. This is simply a transfer from HSA to other account for the amount of the expense, justified by the receipt. Little by little, you can gradually drain your HSA as you use it to pay for qualified medical expenses. Or, you may want to pull an expense (say, surgery or dental expense) forward so at least you can use those HSA funds. Remember, you can spend HSA funds on other people than just yourself.

Alternatively, you can preempt this situation by building up a nice stack of pending reimbursements. This would involved paying for medical expenses out of pocket and delaying your reimbursement from the HSA. You are then entitled to that reimbursement at any time. Eventually, these reimbursements can add up and you can withdraw a large sum from your HSA. My service TrackHSA.com is a great way to keep a record of these un-reimbursed transactions.

3) Invest your HSA, offset by separate account withdrawal

We know that you can invest your HSA account in stocks, bonds, ETF’s, etc. to let it grow over time. If you need cash, consider other sources first. Instead of raiding your HSA, consider withdrawing funds from a different investment account with no / less penalty. Then, you can invest your HSA to “replace” your prior withdrawal.

For example, assume that I need $2k for some reason. Instead of withdrawing from my HSA and facing a penalty, I could withdraw this from a more liquid account, such as an investment account. I could then offset this by investing my HSA in the same instruments that I just sold, so my investment position is maintained. This could also work if the other account (such as a 401(k)) has a withdrawal penalty but it is smaller (say, 10%) than that of the HSA (20%).

4) Use the funds for anything once you turn 65

Once you turn 65 years of age, your Health Savings Account is liberated substantially. You are free to spend your HSA funds on whatever you want, not just qualified medical expenses. Note that any distribution for non qualified medical expenses will be taxed (just like ordinary income), but at least you are getting the funds out of your HSA. This is fair as well because you never paid tax on the HSA contribution – since you didn’t use it for medical expenses, they make you pay it now. However, you may have gotten the benefit of tax free investment earnings on that money for many years. Either way, this is superior to option 1 above as you do not owe the 20% penalty, just the tax. And that 20% can be a huge number

Note: if you have an HSA, you need to file IRS tax Form 8889 each year you make contributions or withdrawals. Please consider using my automated service EasyForm8889.com to quickly and easily generate your HSA Form 8889. In 10 minutes, it asks you simple questions that correctly populates Form 8889 no matter your situation and delivers you the completed PDF.

Paying Taxes: Deducting HSA Contributions

Tax time is upon us again, and this is a reminder that HSA contributions made by an employer, employee, or other relation are tax deductible. However, it is important to differentiate between HSA contributions made through a payroll system and those you make outside of the payroll system. The difference lies in how payroll taxes are applied.

If you or (your employer) make contributions to your HSA account through your payroll system, there really isn’t much to do on your end. Because these contributions are processed in the payroll system, they are flagged as having no income / payroll taxes applied. Thus, come tax time, you will notice your taxable income decreased by the amount of your HSA contribution.

However, you need to take action and deduct contributions you make manually to your HSA. For example, if you have an HSA and you email a check to your custodian (bank) or do an automatic deposit from your bank, you are entitled to tax deductions on this money. Think about it this way: HSA contributions are tax deductible, and you are contributing income that has already been taxed (when you received your check) to your HSA. Thus, you would not be receiving the proper tax treatment of your contributions. Note that you will need to file regular form 1040, not the form 1040-EZ, to classify these contributions as tax deductible.

Having contributions that are tax deductible is the most important of an HSA’s triple tax advantage. This deduction can be quite significant; it will be a savings of:

Contribution x Tax Rate = Tax Savings

Thus, it is definitely in your interest to remember to deduct your HSA Contributions.

Another rarer example is if you have a family member or friend making contributions to your HSA account. In this case, the deduction occurs on the recipient’s income taxes. A gift tax deduction may also occur for the party providing the contributions.

Note: You can make HSA contributions for 2013 up until the tax filing deadline of April 15th, 2014.