Tax Secrets of Health Savings Accounts

Millions of Americans will soon face the daunting task of choosing health insurance for 2023. If you’re one of them, it pays to be aware of little-known benefits—and some pitfalls—of Health Savings Accounts, known as HSAs.

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HSAs are now a key feature of many health-insurance plans, both for employees and individual buyers. There were about 28 million HSAs holding funds as of June 30, 2022 compared with about 17 million in 2017, according to data gathered by Devenir Research. Total funds in them grew to $98 billion at year-end 2021 from $45 billion in 2017.

To be eligible for an HSA, a worker must also have high-deductible health insurance. According to HSA specialist Roy Ramthun, many employees have deductibles of about $5,000 for a family and $2,500 for an individual, although the law allows up to $15,000 for a family and $7,500 for an individual for 2023. This insurance also has out-of-pocket maximums.

To reduce the deductible’s sting, the insurance is paired with a tax-favored savings account—the HSA. Either the plan participant or the employer, or both, can put pretax dollars into this account to pay the cost of out-of-pocket health expenses.

For 2023, the maximum HSA contribution is $7,750 for a family and $3,850 for an individual, plus $1,000 for participants age 55 and older. (The HSA contribution doesn’t have to equal the insurance deductible.) Unused HSA dollars typically can be invested and grow tax free.

Now for a stunning tax twist: HSA owners who don’t withdraw from their accounts—either because they have low health costs or can afford to pay current expenses out of pocket—get tax breaks even better than the ones for IRAs and 401(k)s. There’s no tax on HSA dollars going in, tax-free growth of account assets, and no tax on withdrawals used to pay eligible health expenses.

HSA funds left in the account can compound for years. However, account owners who skip reimbursements as expenses are incurred can be reimbursed for them years later, as long as they keep receipts. They can also take tax-free withdrawals for retirement health costs such as Medicare premiums.

Or HSAs can be a supplemental retirement account: at age 65 the owner can take withdrawals for nonmedical expenses and pay income tax on them, as with traditional IRA payouts.

One committed HSA owner is Paul Fronstin, age 56, who directs health studies at the Employee Benefit Research Institute. Since 2014, he has put the max into his HSA and invested it, paying several thousand dollars a year out of pocket for health costs. Now, his account has more than $60,000, and he plans to keep funding and investing it for use in his late 60s and beyond. Still, he has saved all his receipts in case he needs payouts sooner.

“The HSA is there if I need it, but so far I haven’t needed it,” says Mr. Fronstin.

For workers choosing health coverage, the bad news is that evaluating high-deductible coverage with an HSA can be a brain-busting task unless minimal health costs are expected. Otherwise there are lots of variables to consider that can shift from year to year.

Does the employer subsidize either the insurance or the HSA contribution? What about drug prices? Are treatments for chronic conditions subject to the deductible? In 2019, an IRS ruling stated that some treatments can be covered by insurance without a deductible, a change that can make HSAs more attractive.

“The bottom line is that most people are leaving money on the table if they don’t choose an HSA,” says Mr. Ramthun, who led the Treasury Department’s implementation of HSAs after Congress created them in 2003.

To help with decisions, here are often-overlooked features of HSAs.

An HSA can be a great rainy-day fund

HSA rules allow for tax-free reimbursements of eligible expenses if the account owner can prove them.

So if an HSA owner pays out-of-pocket charges himself and saves receipts, he can make withdrawals for reimbursements years (or even decades) later when he needs cash. Unlike with an IRA withdrawal, the payout will be tax-free.

Note that HSA dollars can reimburse a wider variety of costs than insurance typically covers, such as contact lens solution or a wig after chemotherapy. For a list of eligible healthcare expenses, see IRS Publication 502.

Children of parents with HSAs can qualify for their own HSA.

This is a mind-blower: Under current law, children such as recent graduates can fund their own HSA based on their parents’ health coverage.

Say that Jane, age 23, is employed but still has health insurance through her parents’ high-deductible plan with an HSA. (Many children are covered by parental plans until age 26.) If Jane isn’t claimed as a dependent on her parents’ income-tax return, she can put up to $7,750—yes, the family amount—into her own HSA, even if her parents have funded their own. Jane doesn’t have to fund the HSA with her own earnings; someone else could give her the money for it.

There’s an April 15 loophole

As long as an HSA is set up by year-end, the participant has until the following tax-due date in April-or the date the return is filed, if earlier—to fund it. So those who want to pay out-of-pocket expenses with HSA funds can wait to finish—or begin—funding their accounts until they know their eligible medical expenses for the prior year.

HSAs are portable

As with IRAs, HSAs are owned by individuals, not employers or insurers. If the fees offered by one sponsor are too high, the owner can move it to another.

Spouses age 55 and older get a catch-up break

HSA owners who are 55 and older can put $1,000 extra a year into an HSA.

If one spouse carries the family coverage, the other (if 55 or older) can still get a $1,000 catch-up contribution. But this spouse must put the money into his or her own HSA, as accounts are individually owned.

HSA payouts are often better than itemized deductions.

Although a wide variety of medical expenses count as itemized deductions on Schedule A of the tax return, many filers no longer itemize deductions. People who do itemize can only deduct medical expenses exceeding 7.5% of their adjusted gross income.

HSAs bypass both issues by allowing participants to make pretax contributions.

HSAs can’t be inherited

Unlike traditional and Roth IRAs, HSAs can’t be inherited and used for medical expenses, except by a spouse. Otherwise the assets become taxable at death.

However, the HSA owner’s executor can use funds in the account within a year to pay unpaid medical bills at death and claim prior expenses that were paid out of pocket, if there’s proof of them.

Write to Laura Saunders at laura.saunders@wsj.com