Is a Health Savings Account Better? HSA and FSA Comparison
With insurance premium rates increasing, doctor's fees adjusting upward to keep up, and the cost of medicines continuing to rise, having money available to pay for health care costs has never been more important than now. Paying for medical costs has become an essential part of any individual or family financial plan. This article explores two types of tax-advantaged accounts that you may want to consider as part of your family healthcare strategy: Flexible Spending Accounts and Health Savings Accounts.
Type of Insurance
Healthcare Savings Option
Flexible Spending Account (FSA)
High-Deducatible Health Insurance
Health Savings Account
- Money used to pay tax-deductible medical costs.
- Part of a cafeteria plan offered through an employer.
- "Use it or lose it" means employers get to keep funds not spent after the alloted time.
- You choose how much to allocate.
- Deducted from your paycheck before FICA taxes.
- Tax savings vary.
Timing is everything with the use it or lose it rule. Getting doctors' bills reimbursed in a timely way is a key factor in using an FSA account to its fullest potential.
Flexible Spending Account Definition
A Flexible Spending Account or FSA is an employer-sponsored benefit used to pay healthcare costs.
Types of FSA accounts
There are two types of FSA accounts: a Medical FSA is used to pay medical expenses, while a Dependent Care FSA is used to pay for childcare costs or costs associated with caring for elderly or disabled dependents. It is important to note that if you are presented with both of these options, they are kept in different accounts, and many employers will not allow you to recharacterize the use of these funds if you mistakenly select the dependent care FSA to pay for medical expenses. Sadly, our family learned this distinction the hard way!
How an FSA Works
Your employer withdraws pre-tax money from your paychecks and places it into a Flexible Spending Account to pay for common tax-deductible medical expenses. Employers usually provide a debit card that is directly linked to your FSA account, enabling you to directly pay the doctor, hospital, or pharmacy with your FSA debit card. Sometimes, however, you must first pay for these expenses from your pocket and then have the funds reimbursed. The money is only available for one calendar year plus the 2 and a half months following, then any money left unused will be kept by your employer. This is called the "use it or lose it" provision of an FSA account. Why on earth would anyone want to do this? First, the money in flexible spending accounts can potentially reduce the overall taxes you owe by coming out of your paycheck before they are counted as income.
Second, since this money isn't taxed (because it isn't considered earned income), your dollar stretches a bit further. The reality of this savings can vary depending on your personal tax situation, but for every dollar that comes out of your paycheck through an FSA account to pay for healthcare costs, you get to spend the entire dollar. Contrast this with your own earned income, which is available after federal taxes at anywhere from .85 cents on the dollar to less if you are in a higher tax bracket, and the savings can really add up.
FSA Savings Example
Using this .85 cents on the dollar number for the purposes of our example, say you set aside $2000 to be placed in your FSA account and you are in a 15% tax bracket making 50,000 a year.
Your taxable income is reduced by the FSA savings amount you elect to have withdrawn from your paycheck. If you are paid monthly, $166 will be taken from your pay before it is subject to FICA taxes. The amount of money you save through reduced FICA savings can increase the amount of take home pay you are able to use that is not taxed. Tax situations are affected by many factors, such as income, filing status, and family size, so you should consult with your tax advisor before making financial decisions about how to use an FSA in your personal situation.
How Money in an FSA May Be Spent
Here is a partial list of items ways you can use the funds in your Flexible Spending Accounts. For the complete list of ways to use your FSA, see IRS Publication 969 for the complete list. Use your FSA to pay for:
- The patient co-pay amount due on doctor's bills, lab fees, and hospital costs.
- The deductible due to your insurance company that must be covered before insurance "kicks in" their share.
- Dental expenses.
- Cost of orthodontics.
- Mental health expenses.
- Chiropractic visits.
- Durable medical equipment such as eyeglasses, hearing aids and prosthetics.
- Prescription medications.
Over the counter medications (but in the case of OTC medicines, only those prescribed by your physician).
Who Benefits From an FSA
A flexible spending account can be a helpful way to save on predictable or fixed healthcare costs. People who have monthly prescriptions, or who anticipate costs associated with a known condition such as pregnancy or an illness for which they receive ongoing medical care can benefit greatly from an FSA. Families who are paying for braces or long-overdue dental care may also benefit. The challenge is to "use it" and not "lose it."
Use an online FSA estimation calculator to help figure out how much money to set aside in an FSA, and remember that any unused funds revert back to your employer at the end of your enrollment period.
FSA Catch 22
What happens when an employee is terminated? The funds in an FSA account revert back to the employer. The employer must make the unused FSA funds available to the employee for 2 1/2 months or for the amount of time that the employee pays for COBRA insurance to maintain medical coverage. If the job loss is sudden and unexpected, an employee elects to go uninsured than to pay the costly premiums for COBRA care, the ex-emplyee could potentially lose thousands of dollars when they are financially most vulnerable.
- Savings account that acts like an IRA
- Used to pay for common tax-deductible medical expenses
- Funds belong to the employee until spent
- Not taxed if used to pay for medical expenses
- May accumulate to pay for use in retirement
- Can invest funds in the account
- Earnings from investments in an HSA are not taxed if used for medical costs
- Funds in the account are not subject to "use it or lose it" rule
Health Savings Account Definition
Health Savings Accounts or HSAs are also part of a tax-advantaged healthcare strategy, but unlike Flexible Spending Accounts, the funds in the accounts may be kept year over year and used for medical expenses when they are needed. Although the funds used in an HSA can be spent on basically the same things as the Flexible Spending Account, the funds belong to an individual or a family and not the employer.
Unused Funds Grow Tax-free
Health Savings Accounts do not have a use it or lose it provision. Unused funds grow tax-free year after year, potentially growing a large nest egg for healthcare costs when an employee will need them most: during retirement. However, as long as a person who own an HSA uses their funds to pay for qualified medical expenses, they can be used at any time medical expenses are incurred.
An HSA Belongs to Individuals
The funds in health savings accounts belong to individuals and are not the property of their employers. Although an HSA can be offered as part of a company's health benefits package, any employee with a high-deductible medical plan can use an HSA and receive the tax benefits. From year to year the definition of a high deductible plan changes.
As a result, if an employee makes contributions to the Health Savings Account during a period of employment, then changes jobs or is terminated for any reason, the funds stay with the employee.
Because a health savings account belongs to the employee, it behaves somewhat like an Individual Retirement Account. Like a Roth IRA, funds in the account can grow tax-free, and according to IRS publication 969, if the funds are used in the account after retirement to pay for medical expenses, they can be used tax free as well. You can invest funds in an HSA into investments which can earn a higher rate of return than a traditional savings account.
HSA Can Be Used in Times of Financial Hardship
If you experience an unexpected hardship such as a job loss, the funds in an HSA can be used for non-medical expenses, however the funds will incur a tax penalty for the year the funds are withdrawn for non-medical reasons. This makes an HSA a nice to have backup nest egg. Consider the benefits of having an additional source of emergency funding available "just in case." An HSA with a healthy savings amount would help anyone sleep better at night.
Who Benefits From a Health Savings Account?
People who are relatively healthy and who do not incur significant medical costs year after year are probably the best candidates for owning an HSA and building a large medical savings amount over time. Paying the high deductible in a high deductible medical plan year after year would probably not be cost effective. Some financial experts recommend HSAs as a good savings strategy for young people who are in the early stages in retirement savings. It is a good idea to save up at least the amount of your family's yearly deductible amount, and then, if possible, continue to build additional savings for a catastrophic medical event.
Learn More About FSAs and HSAs
Helpful links for Flexible Spending Accounts and Health Savings Accounts: