Health savings accounts are easily misunderstood or confused with their distant cousins, flexible spending accounts, and those who qualify often end up passing on the chance to save valuable tax dollars. If there’s one thing to remember about HSAs, it’s the triple tax break, which allows contributions, earnings and withdrawals to be made on a tax-free basis.

There’s an estimated 30 million HSAs holding more than $82 billion in assets, according to the recent Devenir HSA Market Survey. That represents only a fraction of Americans who qualify for an HSA (employees enrolled in high-deductible health plans). One in three adults enrolled in a HDHP doesn’t have an HSA, according to a national survey conducted in 2016 by Jama Network Open. Among those who have HSAs, the majority of holders don’t even contribute to it.

Tax-Free Contributions to an HSA

The first tax advantage of having an HSA is the ability to make contributions to the account without being taxed. Workers can contribute pre-taxed dollars via payroll deductions or make direct contributions that qualify as tax deductions when filing taxes. Employers can also match contributions, although that’s optional, and that amount isn’t subject to income tax.

In other words, contributions are excluded from gross income if the employer makes them and deductible from taxable income if the individual account owner makes them.

The average total contribution stood at $2,859 in 2020, slightly down from $2,959 the year prior, according to data from the Employee Benefit Research Institute. Those who don’t contribute to their HSA cite reasons ranging from already having sufficient savings to saving for healthcare in other non-HSA accounts. But individuals are still far from their annual HSA contribution limits, which are set at $3,600 for people with individual coverage in 2021 and $7,200 for those with family coverage. Individuals over 55 who are not yet enrolled in Medicare are able to make an additional $1,000 catch-up contribution.

Contributing regularly to an HSA can help save tax dollars in the long run. For example, a married couple with family coverage contributing the maximum amount every year for 20 years can realize about $20,000 in tax savings over that period.

Tax-Free HSA Growth

The second tax advantage of HSAs is that interest or earnings coming from the account are tax free. Although it’s not always known, HSAs offer the ability to invest a portion of the account balance. This is possible if the account holder has a minimum balance, often $1,000 to $2,000, and deems that he or she won’t need the cash for any withdrawals in the near future. 

Very few HSA holders take advantage of investing their account with only 9% of HSAs in 2020 being invested, up from 2% in 2011. This is mainly because most HSAs are new and don’t meet the minimum balance requirement. But account owners are also often simply not aware of this possibility.

Building up a larger HSA balance allows holders to better prepare for unexpected medical expenses, especially in the long term, and investing an HSA can help maximize that account balance. Investment options, when available by the HSA custodian, typically mirror those of individual retirement accounts and can include certificates of deposit, money market funds, stocks, bonds and mutual funds. But unlike in an IRA, earnings aren’t taxed.

Some personal finance experts even recommend paying for medical expenses out of pocket in the early years of an HSA, and instead investing HSA balances and keeping the ability to withdraw the money from the HSA at retirement.

Tax-Free HSA Withdrawals

The third tax advantage of having an HSA is the ability to make withdrawals, also called distributions, from the account on a tax-free basis as long as the money is used for qualified healthcare expenses. If a withdrawal is used for a non-qualified item, it will be subject to regular income tax, and for those under 65, there’s an additional penalty of 20% of the amount withdrawn.

Since 2018, distributions have held steady with about 60% of accounts making withdrawals on a yearly basis, and account holders have withdrawn on average between $1,700 and $1,900, according to the EBRI.

The scope of qualified items has been expanded in recent years. Withdrawals for premiums for COBRA coverage, long-term care insurance and health insurance while receiving unemployment compensation are tax free. Expenses related to Covid -19 such as the cost of home testing, personal protective equipment including masks, hand sanitizer and sanitizing wipes are also eligible expenses under an HSA. And HSA dollars can also be used for telehealth and mental health services. Despite this expansion, the average annual distribution fell to an all-time low of $1,714 in 2020, likely due to the lower use of healthcare services during Covid.

There are a few caveats to these tax advantages. The main one is that HSAs are only available to people enrolled in HDHPs. Another caveat concerns the states of California and New Jersey, which tax HSA contributions and gains, but still allow withdrawals for qualified expenses to be made tax free.

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