HSA vs FSA Breakdown

What is an HSA?

An HSA is a tax-exempt trust or custodial account that is used to pay or reimburse certain medical expenses.

In 2024, about 39.3 million HSAs were covering 59.3 million people. About 57% of employees who had the option to participate in an HSA in 2024 did so. One caveat is that to be an eligible individual, you must be enrolled in a high-deductible health plan (HDHP). For 2026, the parameters to qualify for a high-deductible health care plan include:

Minimum annual deductible:

·        Self-only coverage: $1,700

·        Family coverage: $3,400

Maximum annual out-of-pocket (excluding premiums):

·        Self-only coverage: $8,500

·        Family coverage: $17,000

To be eligible for an HSA, you must meet both the deductible and threshold requirements listed above.

The annual contribution limit for 2026 is $4,400 for an individual with self-only coverage and $8,750 for an individual with family coverage.

The Benefits of an HSA and How They Work

HSAs are a great way to reduce taxable income for those who are eligible and offer the benefit of tax-free distributions for qualified medical expenses that were incurred after the HSA was established.

The mechanism of contributing to an HSA can vary depending on whether it is done through payroll or by making a direct (after-tax) contribution.

If your employer offers an HSA, you can elect to have contributions made via pre-tax salary reduction. These contributions are excluded from wages, so they never enter taxable income for federal income tax or Social Security/Medicare. Because this is done via payroll, you will not need an additional form at tax time to show these contributions, as they will be reflected on your W-2.

For those who make direct contributions to a custodian outside of payroll, you will claim those on Form 8889 as an above-the-line adjustment on Form 1040. Form 5498-SA will be provided by the custodian for any direct HSA contributions; however, custodians must give you a copy by May 31, so many people use their year-end HSA statement to show proof of contributions made in that tax year.

For those who want to save on taxes but are not strapped for cash flow (meaning they do not depend on the HSA to pay their medical expenses), they can pay medical expenses out of pocket and let the HSA keep growing.

Once compound interest kicks in and the account grows, they can then take tax-free HSA distributions down the road, as long as they are linked to qualified medical expenses. Keeping an Excel sheet is important for HSA usage so that you can prove your distribution had a corresponding medical expense. Some HSA custodians provide features to link receipts to expenses.

This strategy allows the investor to never touch the principal of the HSA and instead take distributions from the growth. Over time, they can build a substantial HSA balance. After age 65, you can take distributions for non-medical purposes without incurring the 20% penalty; however, the distribution will be subject to ordinary income tax.

What is an FSA?

For those who are not eligible for an HSA because they do not participate in a high-deductible health care plan, they may use a flexible spending account (FSA).

The first difference with an FSA is that, by definition, it is an employer-sponsored cafeteria plan arrangement under Section 125. Unlike an HSA, where you can contribute as long as you are eligible, even if your employer does not provide one, an FSA’s eligibility requirement is that your employer provides one (as well as you being an eligible employee under that plan, e.g., working full-time).

FSAs can be broken down into three main types:

Health FSA

·       Used for qualified medical, dental, and vision expenses for you, your spouse, and dependents

·       Funded by salary and sometimes employer contributions, which are excluded from federal income tax and usually Social Security/Medicare taxes

Limited-Purpose FSA

·       These are typically paired with an HSA, as they have limitations such as only being able to be used for dental and vision expenses

·       Pre-tax advantages are the same as Health FSAs, with the added narrower eligible expenses

Dependent Care FSA

·       Used for eligible child or dependent care

·       Has its own annual limit and separate qualifying rules

·       Does not reimburse medical expenses

Keep in mind that having a general-purpose FSA usually disqualifies you from participating in an HSA. For those who want to take advantage of an HSA without draining the account on dental and vision expenses, a limited-purpose FSA is a great option.

Spending Difference

The biggest difference between an HSA and an FSA is that FSAs do not carry balances over year to year. Meaning, if you don’t spend it, you lose it. Unused amounts are returned to the plan at the end of the plan year.

In 2023, an estimated 47% of FSA users forfeited funds, averaging about $422 per forfeiture, totaling roughly $4.5 billion in unspent FSA funds.

Many plans have a grace period of about 2.5 months after the end of the plan year to give participants a slight cushion to incur expenses.

If you want guidance on how best to utilize these accounts, don’t hesitate to reach out to our team, which is comprised of tax professionals and financial advisors.

For more details on qualified medical expenses from an HSA, read Co–Chief Investment Officer and CEO John-Mark Young’s article, Health Savings Accounts: Maximizing Eligible Expenses and Strategic Tax Planning. John-Mark outlined many useful qualified expenses that may have flown under your radar. For myself and my near-sighted friends reading this, contact solution and contact lenses are on that list!