Introduced in 2004, health savings accounts (HSAs) have become a popular option for those who are not insured under a traditional health plan. The account, when combined with the required high deductible health insurance plan, allows consumers to save for future medical expenses with tax-free dollars.

Though using an HSA along with a high deductible health insurance plan can bring down the overall cost of health care for some people, it's not the best option for everyone. Before considering an HSA for yourself or your family, learn how the accounts work, who can participate, how much you can contribute, and what your out-of-pocket costs could be.

What Is a Health Savings Account (HSA) and a High Deductible Health Plan (HDHP)?

An HSA is a special account into which you deposit pre-tax money for the purpose of paying future medical expenses for yourself or your family. Before you can establish an HSA, you must enroll in a high deductible health plan (HDHP), sometimes called a "catastrophic" health plan.

With an HDHP, you will pay lower premiums but higher annual deductibles and out-of-pocket maximums than you would with a traditional health plan. You must meet your deductible before your HDHP begins covering your medical expenses. Once your deductible is met, your plan, typically, will pay a percentage of your medical costs until you reach your out-of-pocket maximum. After you have spent the maximum amount, the HDHP will pay 100% for in-network covered services.

Combined, the HSA and HDHP offer an alternative to traditional health insurance that better meets the needs of some individuals and families.

These are some of the advantages an HSA/HDHP plan offers:

Lower fixed cost. HDHP premiums are typically much lower than those for other health plans because HDHPs do not pay for the first several thousand dollars of medical expenses. The idea is that the money you save on premiums can be used to fund your HSA, which you will tap to pay for all medical expenses not paid by the health plan.

Tax savings. First, as an HSA owner, you can make pre-tax contributions to your account, or you can deduct your post-tax contributions from taxable income on your Form 1040, whether or not you itemize deductions. Second, you will enjoy tax-free interest earnings and investment growth within your HSA. And third, you can withdraw money from your HSA tax-free to pay for qualified medical expenses. (For more information about HSAs and taxes, read IRS Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans. To order the publication, call 800-TAX-FORM or visit the IRS online, at www.irs.gov.)  State tax treatment of HSAs varies.

Account ownership. Unlike a health reimbursement arrangement (HRA), which is owned by a sponsoring employer, you own your HSA. That means the account goes with you when you leave the company, even if it was established and funded as an employer-sponsored benefit.

Unlimited accrual. Whereas a flexible spending account (FSA) requires participants to "use or lose" their account contributions each year, an HSA allows unused funds to roll over from year to year. There is no limit on how much you can accumulate in your HSA for future use.

Eligibility Requirements for an HSA

To be eligible for an HSA, you:

• must be covered by a qualified high deductible health plan that has a deductible of at least $1,100 for individuals and $2,200 for families (some plans offer a no-deductible or low-deductible benefit for preventive care only); your annual out-of-pocket expenses, including deductibles and copays, cannot exceed $5,600 (self only) and $11,200 (families), but if yours is a network plan, it may apply higher out-of-pocket limits for non-network services
• cannot be covered by any other insurance that would pay for medical expenses, except those that provide benefits only for the following items: accidents, dental care, vision care, disability, long-term care, worker's compensation, and specific disease or illness, if the policy pays a specific dollar amount on claims
• must be younger than age 65 (not eligible for Medicare benefits)
• can't be claimed as a dependent by someone else
• do not have to have employment income, and
• can earn any amount -- there are no income limits for HSA eligibility.

You may or may not be eligible for an HSA if your employer offers a flexible spending account or a health reimbursement arrangement (HRA); it depends on the particular FSA or HRA the company offers.

The best way to determine if you meet all HSA eligibility requirements is to consult an insurance professional or other HSA advisor before establishing your account.

Establishing an HSA

Many employers offer HSA's as part of a benefits package. If an HSA is not offered as one of your employee benefits, you can establish an account at any number of banks, credit unions, insurance companies, or other entities that meet IRS requirements. When shopping for a place to open your HSA, start by inquiring at institutions where you already are a satisfied customer. You also can get a list of participating banks and plan administrators from HSA Insider, at www.hsainsider.com.

The account you open should pay interest -- there may be a minimum balance requirement before interest accrues -- and provide the opportunity to invest in mutual funds, stocks, and bond s (just like an IRA or 401(k) does).

You can complete all the paperwork and make the required minimum deposit to your HSA prior to your HDHP coverage becoming effective. However, your account is not officially "established" until your health plan coverage begins.

Contributing to an HSA

Contributions to an HSA can come from you, your employer (if the company offers such a benefit), or both.

For 2008, the maximum contribution, from all sources, for individual coverage is $2,900, and the maximum contribution for family coverage is $5,800. A catch-up provision of $900 ($1,000 in 2009 and beyond) also applies for participants who are between 55 and 65 years old. (You cannot continue to contribute to an HSA after you enroll in Medicare.)

Contributions can be made monthly, in a lump sum, or on any schedule and in any amount you like, so long as you meet the HSA administrator's minimum deposit requirements and do not exceed the annual maximum contribution limit.

Paying Your Medical Expenses with an HSA

You can withdraw funds from your HSA, tax-free, to pay for any qualified medical expense incurred after you established your account. Qualified medical expenses are defined in IRS Publication 502, Medical and Dental Expenses (available at www.irs.gov). 

Because nobody approves or declines your HSA withdrawals, it is your responsibility to accurately determine what is a qualified medical expense and what is not. If your HSA money is used for anything else, you will pay taxes on the withdrawal. If you are not disabled or older than 65, you also will be subject to a 10% penalty. Keep receipts for all your expenditures, in case you are audited.

If your HSA administrator has provided you with a checkbook or debit card, you can pay your health care providers directly from your account. Otherwise, you must pay with your own money and then reimburse yourself from the account.

Though many expenses can be paid for with HSA funds, healthcare premiums cannot, with these exceptions:

• long-term care insurance premiums (the amount considered a qualified medical expense depends on your age, as explained in IRS Publication 502)
• premiums for continuation of health insurance under COBRA
• premiums for health coverage while you are receiving unemployment compensation, and
• medicare premiums, deductibles, and copays (but not a Medicare supplemental insurance, or "Medigap," policy, if you are over 65).

Check with your HSA administrator or other qualified advisor before taking a questionable distribution or using HSA funds to pay premiums.

Is an HSA Right for You?

Whether an HSA will be the best option for you depends on your own particular circumstances and goals. For example, if you would rather pay higher monthly premiums for the guarantee that you will not have to pay thousands of dollars out of pocket, then you might prefer a traditional health plan. An HSA also would not be a good option if you were not sure you could contribute and maintain a high enough balance to cover the entire deductible at all times.

If, however, your main priority is choosing the lowest-cost option, you'll have to do a comparison between an HDHP/HSA plan and a traditional health plan. The evaluation can be somewhat complex, because you will be factoring in tax savings for the HSA, and making projections about how high your medical expenses are likely to be in the coming years.

For help determining whether an HSA is the best option for you, consult an account administrator or other HSA or insurance advisor. (To learn about health insurance benefits granted you by law, read Nolo's article Getting the Most From Your Health Insurance.)