The American healthcare system is expensive and confusing, but for most employers, the choice boils down to HSA or FSA. Both have benefits and shortcomings, so it's important to know the difference.
Employer-provided health plans are the keystone of the American healthcare system, with health savings accounts (HSAs) and healthcare flexible spending accounts (FSAs) among the most prevalent methods of helping employees cover costs. As pretax accounts, these options can help cover copays, prescriptions and other necessities, but they have some caveats. While both savings account styles aim to provide a similar benefit to your employees, namely in how they impact taxable income, it's important to know the similarities and differences between them.
What is an HSA?
A health savings account is pretty much what its name suggests – a savings account set up for the sole purpose of covering healthcare costs. Provided by employers in concert with a high-deductible health plan (HDHP), an HSA is an employee-owned account used to squirrel money away for future health expenses.
Contributions, interest earnings, distributions and other HSA funds are tax-free. In most cases, the funding for an HSA comes directly from an employee's pretax income, though additional tax-deductible contributions can be made independently as well. Employers and other individuals can also contribute to an HSA.
"We kind of look at it as a triple tax benefit," Melissa Sotudeh, certified financial advisor and director of advisory services at Halpern Financial, told U.S. News late last year.
Over the course of a year, the amount of money in an HSA can grow as contributions are made. Though the account is largely tax-free, the IRS does set an annual contribution limit based on the type of coverage. According to the agency's guidelines for 2020, accounts for individual coverage have a maximum contribution of $3,550, while family coverage has a max of $7,100.
Whether they come from an employee, an employer or both parties, contributions to an HSA do not expire. An HSA can roll over funds from one year to the next and can follow an employee after they switch jobs.
Withdrawals from an HSA are only taxed if they're used for an ineligible expense, at which point the distribution is marked as gross income and hit with a 20% income tax penalty. If the employee is over 65 years old, however, the penalty on their income tax is ignored, though it is still included as gross income.
COBRA premiums can also be covered by an existing HSA as a tax-free expense, though an HSA is not subject to continuation under federal guidelines. Furthermore, other health insurance premiums outside of COBRA are not covered by an HSA.
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What is an FSA?
Like its newer counterpart, a healthcare flexible spending account – commonly referred to as a health FSA – is a type of savings account that helps employees cover qualifying medical costs.
FSA funds are only available if an employer offers the option to their employees and the accounts are owned by said employer. Most funding for an FSA account comes primarily from pretax deductions from an employee's paycheck, though their employer can also contribute. Unlike with an HSA account, the amount of pretax contributions an employee makes is determined during open enrollment, requiring employees to consider how much they will need to save to cover the entire year's health costs.
There are two types of FSAs – general purpose and limited purpose. A general-purpose flexible spending account can fund eligible healthcare expenses – including medical, prescription, dental and vision care – in the benefit plan year. A limited-purpose flexible spending account can only be used for dental and vision. General-purpose FSAs can be used with any type of health insurance, while limited-purpose FSAs are usually offered along with an HSA and a health plan with a high deductible.
The federal government and the IRS set a contribution limit for FSAs each year, though this type of account relies on the IRS' cost-of-living adjustments. For both general-purpose and limited-purpose FSAs, the IRS has established a contribution limit of $2,750 for any qualified medical expenses in 2020.
FSAs cannot be used for anything other than eligible medical expenses, nor can they cover COBRA premiums or other health insurance plans.
HSA vs. FSA
Both HSAs and FSAs are relatively new concepts in the American healthcare system that come with some big tax benefits. HSAs were established under the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, while FSAs were created in the Revenue Act of 1978. In both instances, lawmakers sought to establish a tax-advantaged way to help American workers cover their healthcare expenses.
While there are some major similarities between a health savings account and a flexible spending account, there are some glaring differences to keep in mind. Here are some ways the two types of accounts handle medical expenses differently.
1. FSAs require an employer; HSAs do not.
The only way someone can obtain an FSA is through their employer. In fact, any employee can get an FSA, whether or not they actually have health insurance. While most HSAs are also obtained after joining a company, they require the person getting an account to have an HDHP.
2. Self-employed individuals can get an HSA.
While self-employed individuals are unable to obtain and contribute to an FSA, this isn't the case for an HSA. Again, the major eligibility factor for an HSA is that the account holder has and maintains a qualified HDHP.
3. HSAs do not expire; FSAs are "use it or lose it."
One way to look at these two accounts is long-term vs. short-term planning. HSAs act like any other savings account – they hold on to your money until you need it and can accrue interest in many cases. FSAs, however, require that you use up any money you've contributed by the end of the year. Any unused funds vanish at the end of the year. Employers can offer to carry over $500 from one year to the next in an FSA, but that's an optional employee benefit.
4. HSAs offer contribution flexibility.
Both accounts can be funded through a deduction from an employee's paycheck. Situations can change over the course of a year, so during circumstances where money is tighter than normal, employees with HSAs can adjust their contributions at any time during the year. Those with an FSA, however, must wait until the beginning of the next year to change their contribution amount.
5. Benefit rollover differs between the two.
Along with its year-to-year rollover of funds, an HSA can be used by an employee even after they leave the employer that provided it. For all intents and purposes, the employee owns the money in an HSA. Conversely, an FSA is owned by the employer, so it does not follow the employee after they leave.
Considering your options
The well-being of your employees and their loved ones should be a priority for you as a business owner. Without a safety net, employees can experience financial stresses that become a distraction at work and impact their productivity. If you are in the process of figuring out your company's healthcare solution or thinking about making a change, remember that both types of savings accounts can cover healthcare costs with some form of tax savings, but the one that works best for your business is up to you. [Read related article: Companies With the Best (Real-Life) Employee Benefits]