What is a Health Savings Account (HSA), and How Does it Work?

Feb 10

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You have various investment options at your fingertips to help save for both immediate and future healthcare expenses; a health savings account (HSA) is one such option. HSAs were first introduced back in 2004 and have since become extremely popular among investors. According to leading HSA provider Devenir, $137 billion in assets were held in over 38 million accounts by mid-2024—compared to just $3.4 billion in 6.3 million accounts in 2007.

So, what exactly makes HSAs so appealing? This post details key features that attract investors to HSAs, explains how they work, and provides important information you need to familiarize yourself with before opening an HSA. Let’s dive in…

What is an HSA?

An HSA is a special type of savings account offering tax advantages (to be discussed shortly) and designed to help you cover various healthcare expenses such as medical treatments, diagnostic tests, eyeglasses, dental care, deductibles, co-pays, prescription drugs, and some elective procedures. You can find a complete list of eligible expenses on the IRS website.

How does an HSA work?

You can open an HSA account at any bank, credit union, or insurance company that offers one or do so directly through your employer if offered. Should you go with the latter, you can make pre-tax contributions via payroll deductions (similar to a 401k); if you live in New Jersey or California, however, these contributions are taxed for state income tax purposes. If you open an HSA independently, you can make deposits into the account and then claim them as deductions when filing your taxes.

After opening the account, you can choose the amount of money you'd like to contribute each year provided it doesn't exceed government-mandated limits (see below) and then invest the account balance in mutual funds, stocks, and/or other investment tools—depending on the provider—after your HSA is funded. While such investments sometimes carry additional risk, they can potentially help you save more for retirement over time.

When you need to use the funds, you’ll typically have multiple options to pay for qualified out-of-pocket healthcare expenses that include submitting for reimbursement, using an HSA debit card or paper checks, or making online bill payments through your provider.

HSA eligibility requirements

Not everyone can open an HSA, with specific qualification prerequisites in place to do so (e.g., enrollment in an HSA-eligible health plan in the absence of other health insurance); as of 2025, health plans have a minimum annual deductible threshold of $1,600 for individuals ($3,200 for families) with out-of-pocket maximums (excluding premiums) not exceeding $8,050 for single coverage ($16,100 for family coverage).

Additional prerequisites include that you must be at least 18 years of age and cannot be enrolled in Medicare (Part A or Part B) or Medicaid, nor can you be claimed as a dependent on someone else’s tax return. Click here to review all HSA qualification requirements on the IRS website.

HSA benefits

HSAs have several important advantages beneficial to investors that include:

Triple tax advantages: You can make pre-tax contributions (or claim deductions for after-tax contributions) and use the money to cover qualified expenses in the absence of taxes, with the amount in the account growing tax-free. (Note: In addition to California and New Jersey imposing a state tax on HSA contributions, also keep in mind these two states tax any interest or capital gains earned on your HSA. In addition, New Hampshire and Tennessee tax dividends and interest on HSA accounts if all combined dividends and earnings exceed certain thresholds.)
Indefinite rollover funds: Unlike with a flexible spending account, you don’t need to spend the balance in your HSA account every year as any leftover money automatically rolls over to the next one indefinitely until used.
Ownership and portability: If you change health insurance plans, work for a new employer, or retire, you’ll still own your existing HSA.

HSA drawbacks

Health savings accounts also have some disadvantages. In addition to strict eligibility requirements (which we’ll discuss shortly), keep in mind the following limitations:

Tax on excess contributions: If you contribute excess funds beyond annual limits, you’re on the hook for a 6% tax on the same (if you have an HSA through your employer, any contributions your company matches also count towards your annual limit).
Early withdrawal penalties: Any amount withdrawn for non-medical purposes is subject to both income taxes and a (staggering!) 20% early withdrawal penalty for those under age 65, with HSA withdrawals made for non-medical uses after this age still subject to tax but not incurring this consequence.
Inability to own an FSA: When you open an HSA, the IRS will prevent you from also having a flexible spending account; but you can qualify for a limited purpose FSA (if your employer allows) and use this exclusively for vision and dental expenses such as cleanings, fillings, vision exams, contact lenses, lens solution/cleaner, and prescription glasses.

2025 HSA contribution limits

Contribution limits depend on your age and the date you become eligible, and the IRS may change these each year to account for inflation, rising healthcare costs, and other factors. For 2025, annual limits are as follows (note individuals aged 55+ can contribute an extra $1,000 above these thresholds, known as a “catch-up contribution”):

Individuals: $4,300
Families: $8,550

Those who don’t own a high-deductible health plan (HDHP) for the entire year can only contribute a portion of allowable limits. For example, if you were enrolled in an HSA-eligible plan for six months, take that number and divide it by 12 months (giving you 0.5), and then multiply 0.5 by either $4,300 or $8,550 (2025 contribution limits) to calculate the amount you can contribute for the year.

An exception to this rule exists, however. Known as the “13-month rule,” “last-month rule,” or “full-contribution rule,” this helps determine whether you can make a full year’s contribution despite a lack of coverage for the entire year. You must be HSA-eligible on the first day of the last month of the tax year (typically December 1) to qualify for the entire year, but this only holds true if you stay enrolled in an HSA-eligible plan from December 1 through December 31 of the following year (the “testing period”). Should you meet the last-month rule requirement, you can make a maximum contribution for the current year.

To illustrate, those who become HSA-eligible on November 1, 2025 can only contribute 2/12ths of the annual contribution limit under the general rule but can contribute the full annual amount for 2025 under the last-month rule—provided they stay HSA-eligible for the remainder of 2025/2026. Ineligible contributions become taxable income and incur a 10% penalty in the event of testing period violations.

Who can contribute to an HSA?

Limits remain the same regardless of HSA contributor, with several different parties able to add money to the account up to the limit:

You can deposit your own funds into the account.
Your employer can make contributions (common with HSAs offered by companies).
Others (e.g., family or friends) can make contributions that give you tax benefits.

In sum: health savings accounts

Eligible for a health savings account? You should definitely consider opening and funding one to specifically help save for healthcare expenses in retirement, especially considering that retiree households spend an average of $8,027 a year on these specific costs.

Still have questions about the same? Schedule a FREE discovery call with one of our CFP® professionals to learn more!

FAQs

If you cancel your HDHP policy, you can no longer make deposits to your HSA but will still own the account and monies accumulated (and will need to adhere to HSA spending rules).
After enrolling in Medicare, you can use the money in your HSA account to pay premiums, deductibles, copays, and coinsurance for Medicare Part B, Medicare Part D, and/or Medicare Advantage plans (Medigap premiums, however, are a different story).
You may still be able to contribute to an HSA after you retire but will need to cease doing so upon enrolling in Medicare. Those aged 65+ can withdraw money from an HSA for non-medical expenses without penalty.
Some companies offer HSAs, others flexible spending accounts (FSAs). Both cover medical expenses, and contributions don’t count toward taxable income. They each operate in unique ways, however, so click here to read about the differences.
As mentioned earlier, you don’t need to spend the balance in your HSA account every year; any leftover money automatically rolls over to the next one indefinitely until used. This feature makes HSAs very appealing for investors who want to save for future medical expenses.