Your Guide to Health Savings Accounts

You know how health insurance works. You pay a premium each month, and even if all you ever get is a cold, that’s the last you’ll see of your money. The health plan usually reimburses doctors and hospitals directly for any health care expenses.

Not so with a health savings account (HSA), which a growing number of employers and institutions now offer. With an HSA, part of your monthly pretax income goes into a savings or investment account for use toward future medical expenses.

An HSA isn't something you have to buy, but an actual savings account in which you deposit money before taxes to pay for medical expenses, according to the U.S. Department of the Treasury. What you do need to buy is a high-deductible health plan (HDHP), an inexpensive health plan that covers your medical expenses beyond your "deductible."

An HSA is all yours. Whatever you don’t spend stays there from year to year, earning interest tax-free. It’s yours even if you change jobs; and once you reach age 65, your HSA turns into a retirement account.

Sound good? It can be. But there can be risks, too, because an HSA also requires you to be more responsible for managing your own health care funds. Here are some issues to be aware of.

How does an HSA work?

An HSA has two parts: the HDHP to cover large hospital bills; and an investment account, in which you save for future medical expenses.

The HDHP is there for you only in the event of major medical expenses, and it has significantly lower premiums than a low-deductible plan. The HDHP typically kicks in once you've spent several thousand dollars out of pocket (or from your HSA). In 2006, for instance, the HDHP is required by law to pay the remainder of your health care expenses after you've spent $5,250 for an individual or $10,500 for a family.

The investment account can be in the form of a traditional savings account or investments in stocks, bonds or mutual funds. Pretax deductions from your paycheck go into this health savings account. Every time you need to pay out of pocket for medical care services, you’ll draw from this account. You’ll never pay taxes on these funds as long as they’re spent on qualified health care expenses.

How do you get an HSA?

HSAs are available through banks, credit unions and insurance companies. Many employers now offer HSAs, as well. You may enroll in an HSA is you have an HDHP and no other health insurance. If you are enrolled in Medicare, you cannot contribute to an HSA, the Treasury Department says.

If you change jobs, your HSA goes with you. The money in your account earns tax-free interest, just like an IRA.

Who benefits?

Young people in good health may benefit the most from an HSA, because they tend to have lower medical bills, and over many years the accumulated savings can be significant. Also, if you lose your job or are laid off and are collecting unemployment insurance, you can use your HSA funds to pay for routine health expenses and health insurance premiums, tax-free.

People who have lots of doctor office visits, such as families with small children or people with chronic health problems, often pay more out of pocket through an HSA than through a health maintenance organization.

What else should I know?

To keep your risk down, keep these important facts in mind:

An HSA requires you to plan wisely for the unexpected. Even a broken bone can lead to thousands of dollars in out-of-pocket payments if it requires surgery and physical therapy. Not contributing enough each month could put your financial health in jeopardy.
Skimping on preventive care, such as recommended cancer screenings and other health exams, is never a smart choice. What you might save in the short term could lead to high expenses in the future -- not to mention serious health problems.
Investing requires smart money management to control your risks.

Not everyone is eligible to enroll in an HSA, and not every health insurance plan is HSA-qualified. Your health insurance company or your employer can tell you if an HSA is available to you.