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Health savings accounts: the basics

| MoneyRates.com Senior Financial Analyst, CFA

With the rising cost of health care, consumers need to be well-educated about what health coverage options are available to them. A relative newcomer on the scene is the health savings account, but this option may prove to be the right choice for some.

What is a health savings account?

A health savings account is an account funded with pre-tax dollars, and which is not subject to tax on interest and investment gains while in the account. Distributions from a health savings account are not subject to taxes if used for approved medical expenses. Money withdrawn from a health savings account for non-approved uses is subject to income tax plus a 10 percent penalty, though the latter does not apply if the account owner is over 65 or has died.

These accounts are owned and controlled by the individual, and can be used for current and future health care expenses. Significantly, unlike flexible savings accounts, health savings accounts enable money for health care expenses to be built up over time.

High-deductible health plans and health savings accounts

High-deductible health plans are a necessary companion to health savings accounts. Eligibility for a health savings account is dependent on enrollment in a high deductible health insurance plan, and the two are designed to be complementary.

Health savings accounts allow the individual to save up for expenses that don't exceed the deductible of the high-deductible insurance plan, while using that plan to handle any catastrophic expenses.

Who is eligible for a health savings account?

Besides having to be covered by a high-deductible health plan, people can qualify for a health savings account only if they are not covered by any other health insurance, are not eligible for Medicare, and cannot be claimed as a dependent on someone else's tax return. With regard to this last point, while dependents cannot establish their own health savings accounts, they can be covered by their household's plan.

Advantages and disadvantages of health savings accounts

As described above, health savings accounts enjoy certain tax advantages, which are something of a hybrid between the tax treatment of IRAs and the normal deductibility of health care expenses.

Beyond that, the premise is that they can represent a savings over traditional health insurance arrangements because premiums on high-deductible insurance are much lower than traditional health policies. The premise is that even when uncovered expenses are paid by the individual, these can be exceeded by the tax and premium savings.

The primary disadvantage is that health savings accounts lock up money for health care purposes when you have no way of knowing what your future health care expenses will be. To some extent though, this is true of all insurance -- it represents a payment for something you don't know that you'll actually use.

All of the above is just an introduction to health savings accounts. There are a great many details that should be investigated, but the first step is knowing that this option exists.

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