I’ve written a bit lately about Health Savings Accounts, or HSAs, how HSAs work with state taxes, and the difference between Health Savings Accounts and Flexible Spending Accounts. But, the one question I keep getting is how exactly to use a HSA account.
The Health Savings Account Theory
The idea behind a Health Savings Account, or HSA, is a little bit like a 401k account, or even a 529 college savings plan account. You save money for future expenses like college or retirement, but in the case of an HSA, you are saving for medical expenses. Like with a 401k plan, or an IRA, you get a tax deduction benefit for making contributions. Also, like the other accounts, your money grows inside the account tax free. And, finally, like a Roth IRA, or a 529, you withdrawals for approved expenses are also tax free.
So, theoretically, assuming the world around you proceeded in an orderly and predictable manner, and your budget contained plenty of room for all appropriate spending and savings, then you would contribute regularly to your HSA account, and invest that money, so it could grow over time, into a big reserve that is available to you when you have medical issues down the road. If you are familiar with studying physics, you may remember that in basic physics all the equations work, as long as you are on a frictionless plane, in a vacuum. This is kind of the same thing, for medical finances.
If this doesn’t sound exactly like your life, don’t worry; most people don’t live like that either.
What makes the HSA very different than those other retirement and education accounts is timing. Your child is 10 years old now, they will go to college in eight years. You have no reason to use any of the 529 money between now and then. Likewise, you are 20 years from retirement, so there is no reason to withdraw any money from your IRA or 401k either. Yes, things could change, maybe Junior gets into college a year early, or maybe things go your way and you retire in 15 years, but either way, there is a built in time frame to those accounts. In fact, if you did try and withdraw any of that money sooner, there may be stiff tax consequences.
Medical expenses, however, are not like that. You might need to go the doctor next month, or even tomorrow. In fact, there is a very good chance that you’ll need to withdraw and use money from your HSA account at least once in the next 12 to 24 months. That makes using an HSA unusual for most people.
Using HSA Reality
So, how should you use your HSA in reality?
First, you have to setup an HSA account. Everything starts when you OPEN your HSA account. If you open your HSA on June 1st, and you have medical expenses on June 2nd, you can use HSA money. But, if you open your HSA on June 1st after visiting the doctor on May 31, you can’t use HSA funds for that May visit. So, the most important thing is to open your Health Savings Account as soon as you qualify for it, even if you don’t put any money in it right away!
Second, you have to put money into the HSA. Typically, you can either setup some sort of salary reduction, where money from your paycheck gets directly put into the HSA, or you can link a checking account and transfer money into the HSA, either on a regular basis, or as needed.
Here is where it gets a bit confusing. Many HSA accounts come with a debit card that you can use to pay for your medical expenses. This is great, and it helps with record keeping, however you do not have to use that debit card at all. It is only for convenience. You can actually pay your expenses any way you like — check, credit card, cash — and then reimburse yourself from the HSA account.
What throws people off is that while using the debit card is just like a checking account debit card (you have to have sufficient funds), that functionality has nothing to do with the tax advantages. The tax benefits come solely from the contributions you make to the account. In other words, you get a tax deduction for every dollar you put it, up to the HSA contribution maximum for the year. This is the only thing that matters on your Form 1040, is how much money you put in. You don’t report the money coming out.
How To Withdraw From Your HSA
You do not report the money you withdraw from an HSA to the IRS. And, unlike a Flexible Spending Account (FSA) the company that holds your HSA account won’t require any sort of receipt, or proof, either. You will only need proof if you are audited. Otherwise, no one need cares.
So, how do you actually use your HSA?
The easiest way is to just use your HSA debit card to pay your medical bills, but it isn’t the only way, or even the best way, depending upon your circumstances.
The other way is to pay your bills some other way, and then reimburse yourself. So, perhaps you write a check or use some MasterCard or Visa that you get credit card airline miles or rewards points for. To reimburse yourself, you can either withdraw the money from an ATM using the debit card, or send the money directly to your linked checking account. Your HSA may also provide you checks which you can write to yourself. As long as the total amounts match up over the year, it doesn’t matter how you put the money in and out.
In a lot of ways, this can end up looking like legalized money laundering.
For example, let’s say you open your HSA account on March 1st. On March 5th, you go to the doctor. On March 20th you get a bill for $95. You pay the $95 by mailing in a check. Then, on March 30th, you get paid and $100 comes out of your paycheck into your HSA. On April 5th, you use your HSA debit card to take out $95, and you go to the movies. — That’s all fine. You deduct the $100 contribution, and since there was an allowable $95 medical expense, there are no taxes or penalties on the withdrawal, even though the money didn’t go directly to the doctor.
It can get even stranger. Imagine you have an HSA account open. It has a balance of $50. You fall and go to the emergency room on March 10th. The bill comes to $1300. On March 15th you use your connected checking account to transfer $1300 into your HSA. You wait a few days for the transfer to complete, and then you pay the $1300 bill by calling the billing department and giving them your debit card number over the phone. — That’s fine too. Again, the contribution is what matters. You get to deduct $1300 for making a contribution during the year. It is irrelevant that the contribution was made after the medical expense was incurred. And, the withdrawal is tax-free because you had $1300 in eligible medical expenses, even though they occurred before the contribution was made.
You cannot, however, reimburse yourself for any expense that occurs before your HSA is open, even if you are eligible for an HSA, so open your account, right away.
The key thing to remember is that the money you put IN is your tax deduction. The money you take out does not affect your taxes, so long as it is less than or equal to your medical expenses. You must keep the receipts to prove the amount of the expenses in case you are audited, but no one will ask for them until then.
So, to maximize your deduction, make sure every medical expense you have is either paid from, or reimbursed by, your HSA account, even if you have to put money in after the expense is incurred to do so. Do that, and you’ll maximize your deduction for HSA contributions, which is much better than only getting to write off whatever medical expenses you have above the 10% medical costs deduction.