Until you turn 65 and are eligible for Medicare, you’ll need some type of medical coverage. Whether this means participating in your company’s health plan, your spouse’s company’s health plan or purchasing coverage from the insurance marketplace, you’ll need to figure out which options make the most sense for you.

Key to understanding health insurance is knowing what your plan costs, what it includes, and whom it covers. In this column we unpack two supplemental health savings options worth considering — the Health Savings Account (HSA) and Flexible Spending Account (FSA).

What is an HSA?

HSAs are key features in many health insurance plans, both in group employee plans and for individual buyers. It’s a type of medical savings account that lets you set money aside on a pretax basis to pay for eligible health care expenses.

As such, an HSA allows for tax-free reimbursement or direct payment of eligible health care expenses — but, if asked, you must be able to prove them by producing receipts. Unlike with an IRA, the withdrawals from an HSA will be tax-free if used to pay for eligible expenses. And, unlike an insurance policy, HSA dollars can be used for a broad range of expenses, such as contact lens solution or a wig after chemotherapy.

To be eligible for an HSA, you must be enrolled in an HSA-qualified, high-deductible health insurance plan (HDHP), which for most people means plans with deductibles of about $5,000 for a family and $2,500 for an individual. Additional exclusions include the following:

• You can’t be enrolled in Medicare (that is, you cannot contribute to an HSA if you’re enrolled in Medicare, but you can take payouts if you have an existing HSA).
• You cannot receive coverage through a spouse’s non-HSA health insurance plan or flexible-spending account.
• You cannot be claimed as a dependent on someone else’s tax return.

An HSA works very similar to your retirement plan at work: You (the employee), your employer, or both, put pretax dollars into an HSA to pay for out-of-pocket health care costs. The maximum total contribution for 2023 is $7,750 for families and $3,850 for individuals, plus $1,000 catch-up provision for participants who are 55 and older. You own the assets in the HSA for the life of the account and can access them even if you switch jobs or retire.

Tax benefits are generally better for HSAs than for 401(k)s and IRAs. For one, money going in is not taxed, account assets grow tax-free while held in the account, and withdrawals used to pay for eligible health expenses are also tax-free. (However, if withdrawals are not used for qualified expenses, and you’re under age 65, you will owe federal income tax as well as a 20% penalty.)

Secondly, because at age 65 you can take withdrawals for nonmedical expenses and pay income tax on them, just like a traditional IRA payout, HSAs can be used as a supplemental retirement account. Furthermore, if you skip seeking reimbursement as expenses are incurred, you can be reimbursed for them years later, so long as you have receipts.

Finally, you can use tax-free withdrawals to pay for retirement health costs, such as Medicare Part B and Part D premiums, and Medicare Advantage premiums.

That being said, HSAs may not be for everyone. Evaluating high-deductible coverage with an HSA can be tricky, with lots of variables. For example, your decision to open an account could ultimately hinge on whether your employer subsidizes your health insurance or the HSA, the anticipated cost of future drug prices, and whether treatments for chronic conditions are subject to your deductible. Consulting with a knowledgeable financial adviser may be helpful when sorting through these variables.

What’s a Flexible Spending Account (FSA)?

Like an HSA, an FSA acts like a savings account that lets you set aside money on a pre-tax basis to pay for qualified medical expenses — even many that are not covered by regular insurance. Contributions are deductible from federal income taxes and most states. The contribution limit for 2023 is $3,050, up from $2,850 this year. And similar to an HSA, money held inside the account grows tax-free and withdrawals are tax-free if used to pay for eligible medical expenses.

But there are significant differences between an FSA and an HSA that are worth noting. First, your employer owns the assets in the account, and if you don’t use all the money in your account by Dec. 31 each year, you may revert to your employer. If you have an FSA, you’ve been spared from having to spend the assets during the pandemic (the IRS allowed full carryovers in 2020, 2021 and 2022; but only $570 can be carried over into 2023).

Secondly, FSAs can only be used on eligible health care expenses — there’s no provision to take non-qualified withdrawals and pay a penalty.

Finally, people often confuse FSAs and HSAs — especially how FSAs have a short-term, exclusively medical use, and HSAs can be used for longer-term planning (and non-medical) purposes. You also need to be clear on whether the FSA you are considering has a carry-over provision or “grace period.” A carry over is the fixed amount, set by your employer subject to IRS limits, that can be carried over from one year to the next. A grace period, also at the employer’s option, gives workers an extra 2.5 months (usually until March 15) to spend down their prior-year balance.

Having an HSA or FSA in your corner can be a big help if you or family members are saddled with high or unexpected health care costs not covered by regular insurance. The advisers at Wealth Enhancement Group can help guide you through your choices.

This article was originally published in the Pioneer Press.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. 

Bruce Helmer and Peg Webb are financial advisers at Wealth Enhancement Group and co-hosts of “Your Money” on WCCO 830 AM on Sunday mornings. Email Bruce and Peg at yourmoney@wealthenhancement.com. Securities offered through LPL Financial, member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, LLC, a registered investment advisor. Wealth Enhancement Group and Wealth Enhancement Advisory Services are separate entities from LPL Financial.