What is a Health Savings Account (HSA) and how does it work?

Health Savings Accounts (HSAs) are specialized accounts that let eligible people save, pay, and invest for medical expenses with a powerful set of tax advantages. HSAs are best understood as a three-part benefit: 1) pre-tax (or tax-deductible) contributions, 2) tax-free growth, and 3) tax-free withdrawals for qualified medical expenses. These features make HSAs unique among U.S. tax-advantaged accounts and effective for both near-term medical spending and long-term retirement healthcare planning.

Note: This article is educational and not personalized tax or legal advice. Check the IRS and consult your tax advisor for guidance specific to your situation (see links at the end).

Who can open and contribute to an HSA?

To be eligible for an HSA you must be covered by a qualifying high-deductible health plan (HDHP), and you cannot be enrolled in Medicare or claimed as a dependent on someone else’s tax return. Employer-sponsored HDHPs and individual market HDHPs both qualify if they meet IRS requirements. If you or your spouse participates in a flexible spending account (FSA) in ways that provide first-dollar coverage, that can affect eligibility.

Qualifying HDHP thresholds and HSA contribution limits change each year for inflation. For context, the 2024 IRS limits were $3,850 for individual coverage and $7,750 for family coverage; HDHP minimum deductibles for 2024 were $1,600 (self-only) and $3,200 (family). The IRS typically posts updated limits each year—confirm current 2025 numbers on the IRS website or in IRS Publication 969 [IRS Pub. 969].

How contributions work

  • Contributions may be made by you, your employer, or both. Employer contributions are generally excluded from your taxable income. Employee contributions made through payroll deduction are typically pre-tax under a cafeteria plan; otherwise, they can be made with after-tax dollars and claimed as an “above-the-line” deduction on your federal return.
  • Most years the IRS sets an annual contribution maximum (including employer contributions). Catch-up contributions are allowed for people aged 55 and older.
  • Contributions are prorated in the year you become eligible or lose eligibility. If you’re HSA-eligible on December 1 and remain eligible the rest of the year, special rules may allow you to contribute the full-year maximum; consult a tax advisor before applying that test.

Tax advantages — the “triple tax benefit”

HSAs are often described as having a triple tax advantage:

  1. Contributions reduce taxable income (pre-tax at payroll or deductible on Form 1040).
  2. Investment earnings and interest grow tax-free inside the account.
  3. Withdrawals for qualified medical expenses are tax-free.

Because of those combined benefits, many financial planners recommend maximizing HSA contributions when possible, especially if you don’t expect to spend the money immediately and can invest it for long-term growth.

Qualified medical expenses and recordkeeping

Qualified medical expenses generally include doctor visits, prescription drugs, dental and vision care, certain over-the-counter drugs (rules vary), and other items listed in IRS guidance. Keep receipts and documentation since the IRS can disallow expenses on audit. If you reimburse yourself for a qualified expense years later, keep the original bills and proof of payment to support the tax-free distribution.

If you withdraw funds for non-qualified expenses before age 65, the withdrawal is included in taxable income and subject to a 20% penalty. After age 65, non-medical withdrawals are taxed as ordinary income but are not subject to the 20% penalty — they then behave similarly to a traditional IRA for non-medical distributions.

Portability and rollover

HSAs are individually owned accounts. If you change jobs, switch insurers, or retire, the HSA stays with you. You may roll funds between HSA custodians (trustee-to-trustee transfers) without tax consequences. In some cases you can roll over funds once every 12 months by withdrawing and redepositing, but direct transfers are generally simpler and avoid timing risk.

Investing inside an HSA

Many HSA custodians offer cash accounts plus investment options (mutual funds, ETFs, etc.) once your balance reaches a minimum. Investing HSA funds can accelerate growth for future healthcare needs or retirement medical costs. In my practice, clients who treat an HSA as a long-term investment vehicle — paying current medical expenses from other sources and letting the HSA grow — commonly realize larger tax-advantaged balances by retirement.

See our deep dive on HSA investment options: “HSA Investment Options: Growing Health Savings Over Time” (internal link: https://finhelp.io/glossary/hsa-investment-options-growing-health-savings-over-time/).

Practical strategies and examples

  • Prioritize contributions: If you have a choice between contributing to an HSA or a taxable account, the HSA’s triple tax benefit usually wins for medical and retirement health costs.
  • Use an HSA as a long-term bucket: Pay routine medical costs from cash or an FSA and let HSA contributions grow invested for future, possibly larger, healthcare bills in retirement.
  • Coordinate benefits: If you have access to both an HSA and an FSA, understand the coordination rules. Some employers offer a limited-purpose FSA that preserves HSA eligibility for dental and vision expenses.

Example: A 40-year-old with an HDHP contributes the annual maximum to an HSA and invests those funds. Over 20 years, the account’s tax-free growth can cover substantial health costs in retirement; even modest annual returns significantly multiply contributions because of compounding and tax-free distributions for medical use.

For guidance on when to choose an HSA versus an FSA, see our comparison: “When to Use an HSA vs an FSA: Decision Guide” (internal link: https://finhelp.io/glossary/when-to-use-an-hsa-vs-an-fsa-decision-guide/).

HSAs and retirement & Medicare interaction

  • You cannot contribute to an HSA after you enroll in Medicare; however, funds already in the HSA remain available tax-free for qualified medical expenses.
  • Once on Medicare, HSA funds can pay premiums for Medicare Part B, Part D, and Medigap in certain cases — check IRS rules and your plan.
  • Many people use HSAs to cover early retirement healthcare costs or to supplement Medicare expenses later in life; see our guides on advanced HSA retirement strategies for more detail (internal link: https://finhelp.io/glossary/using-an-hsa-for-retirement-health-costs-strategy-and-rules/).

Common mistakes to avoid

  • Assuming every health-related purchase qualifies: Cosmetic procedures, most general health items, and some OTC purchases may not qualify.
  • Failing to document expenses: Keep receipts and invoices in case of IRS review. If you plan to reimburse yourself later, maintain clear documentation.
  • Ignoring investment thresholds: Some custodians require a minimum cash balance before allowing investments; shop for a provider that fits your investing preferences.
  • Missing coordination rules: Using a general-purpose FSA or having spouse coverage can affect eligibility.

Audit considerations and recordkeeping

HSAs are subject to IRS rules. Save receipts and statements for any medical expense you reimburse with HSA funds. If you reimburse yourself years later, keep the original itemized bill plus proof of payment; the IRS may request evidence to support tax-free withdrawals.

Who benefits most from an HSA?

HSAs are most valuable when you:

  • Are enrolled in a qualifying HDHP,
  • Can afford the deductible or have separate emergency savings for near-term needs,
  • Want a tax-advantaged way to pay current or future medical costs,
  • Are able to invest HSA funds and leave balances to grow for retirement.

If you have chronic conditions with predictable yearly out-of-pocket costs, an HSA can still help, especially if paired with investment and reimbursement timing strategies. See “Using HSAs Strategically When You Have Chronic Health Costs” for case studies and practical tips (internal link: https://finhelp.io/glossary/using-hsas-strategically-when-you-have-chronic-health-costs/).

Quick checklist before opening or changing an HSA

  • Confirm your health plan qualifies as an HDHP for HSA purposes (check plan documents and IRS guidance).
  • Review contribution limits and catch-up rules for your tax year.
  • Compare custodial fees, investment options, and minimums across HSA providers.
  • Plan documentation and recordkeeping processes for medical expenses you intend to reimburse tax-free.

Authoritative sources and where to confirm current rules

Professional disclaimer: This content is educational only and does not replace individualized tax, legal, or financial advice. Consult a tax advisor or financial planner before making decisions that affect your tax or retirement situation.

If you’d like, I can recommend a short checklist for comparing HSA custodians (fees, investment choices, minimums) tailored to common investor profiles.