Benefits Renewing July 1? Should You Choose an HSA or an FSA?

Health Savings Accounts and Health FSAs offer similar short-term tax benefits. But there are trade-offs that may make one account better than the other for you if you're offered a choice.

They're similar, but different. They're distinct, but often confused. And surveys of employees consistently show a level of confusion that suppresses Health Savings Account enrollment because respondents remember the biggest negative aspect of Health FSAs (which participants usually can manage easily with foresight and knowledge) and ascribe it to Health Savings Accounts.

Not all employers offer both plans, in which case benefits-eligible employees don't need to compare the two options. But even when the company offers only one, the choice is between enrolling and not enrolling. And it's critical to have the right information about each plan before deciding whether to enroll.

Defining the Options

So, what are the key features of each of these accounts?

A Health FSA is an employer-sponsored plan that allows employees to elect to receive a portion of their pay in the form of tax-free funds to reimburse qualified medical, dental, and vision expenses, as well as qualified over-the-counter drugs, medicine, equipment, and supplies. All workers who are eligible for benefits can enroll, even if they waive medical coverage. Employees choose the amount (up to their employer's limit, which can't exceed $3,050 for plans that start in 2023). The funds are then deducted from the employee's paycheck in equal amounts per pay period before federal or state (if applicable) income taxes or payroll taxes are applied. The election is binding unless the participant experiences a qualifying life event (like marriage or divorce, or the birth, adoption, or death of a dependent).

You can spend the full election at any point during the plan year. Funds not spent by the end of the plan year are forfeited to the employer. The company can offer one of two extenders - a grace period that extends the time to spend the unused funds an additional two and a half months or a carryover that allows a limited amount ($630) to flow into the next plan year.

A Health Savings Account is a personal financial account that qualified individuals (who can be employees, self-employed, or unemployed) can set up if they meet certain eligibility requirements. Contributions remain in the account until spent (no forfeiture of unused balances because there's no set plan year). Pre-tax payroll deductions offer the same tax benefits as Health FSA elections. You can adjust your contribution levels during the year and can contribute up to the statutory limit of $3,850 (self-only coverage) or $7,750 (family plan), plus up to a $1,000 annual catch-up contribution beginning the year that they turn age 55.

Health Savings Account balances earn interest and can be invested in mutual funds, stocks, bonds, ETFs, and other options (the list varies by administrator). Health Savings Accounts are held in a trust that is portable, so owners can take it with them from job to job and active employment to retirement. You name a beneficiary to receive a remaining balance when you die.

When a Health FSA May Be the Better Option

Here are some situations in which employees given a choice might want to participate in the Health FSA program:

1. You don't qualify to open and fund a Health Savings Account. You may not be enrolled in HSA-qualified coverage or may be enrolled in Medicare or you, your spouse, or your parent has a general Health FSA (which automatically covers spouses, tax dependents, and children to age 26, even if they're not covered on the employer's medical plan).
2. You know that you'll incur high expenses early in the plan year. In this case, you're certain that you'll spend all your election (no risk of forfeiture). You can take advantage of the uniform-coverage rule that gives you access to your full election at the beginning of the plan year. Health Savings Accounts don't allow you to tap future payroll deductions (although some administrators offer a program that delivers a similar benefit).
3. The out-of-pocket expenses that you expect to reimburse will be incurred by an adult child who's no longer your tax dependent. Because a Health FSA falls under many of the rules that govern medical plans, it covers children to age 26, whether the child is or isn't your tax dependent. In contrast, a Health Savings Account, which is a financial account, limits tax-free reimbursements to account owners, spouses, and tax dependents. Thus, you can reimburse your adult non-dependent child's qualified medical, dental, and vision expenses from a Health FSA, but not your Health Savings Account.

When a Health Savings Account May Be the Better Option

Health Savings Accounts are far more flexible than, coincidentally, Health Flexible Spending Arrangements (FSAs). And they're not time-bound. This combination of benefits makes them an ideal option in many situations, including:

1. You have expenses beyond the Health FSA limits. The maximum election to a Health FSA is $3,050 and the maximum contribution to a Health Savings Account is more than double that amount ($7,750) for family coverage.
2. You're not sure whether you'll spend the funds this year. You never forfeit Health Savings Account balances, so the funds are available to reimburse qualified expenses next year or decades hence. You can also vary your contributions - start, stop, increase, or decrease payroll deductions or personal deposits - during the year as your needs and budget change.
3. You want to build an emergency medical fund. If you're generally healthy, your out-of-pocket medical, dental, and vision expenses are usually random. You may sleep better if you've steadily funded an account that you can tap to pay for these services rather than put the expense on a credit card and pay it back at a high interest rate.
4. You want to build a balance to fund your medical expenses in retirement. Medicare charges premiums and cost-sharing (deductibles, coinsurance, and copays). It doesn't cover some services that employer-sponsored plans reimburse. And Medicare has limited dental or vision expenses. Saving for these expenses through a Health Savings Account is more tax-efficient than through a tax-deferred or Roth retirement account. Translation: You have more spending power per dollar of current consumption sacrificed if you place a dollar into a Health Savings Account than into any other account.

When Both May Be the Ideal Option

There are cases when a combination of a Health Savings Account and a limited Health FSA may be ideal. If you're covered by a general Health FSA, which provides first-dollar reimbursement of qualified medical, dental, vision, and OTC expenses, you can't open or fund a Health Savings Account. The Health FSA is considered a medical plan, and its first-dollar coverage (which simply means that it doesn't apply a deductible no less than the statutory limit of $1,500 for self-only or $3,000 for family coverage required of an HSA-qualified plan).

If your company offers a Limited-Purpose Health FSA, however, you can enroll in that plan without losing your eligibility to open and fund a Health Savings Account. A Limited-Purpose Health FSA restricts reimbursement to dental and vision expenses. These expenses aren't medical, so the plan isn't disqualifying.

But note that the Limited-Purpose Health FSA is, like a general Health FSA, a time-bound plan with the possibility that you'll forfeit unspent balances. You must be reasonably certain that you'll incur qualified dental and vision expenses if you want to pursue this approach.

Here are some situations when enrolling in both plans may make sense:

1. You want to maximize your tax savings. If you're covered on a family plan and are under age 55, you can contribute up to $7,750 to your Health Savings Account this year and elect up to $3,050 (or less, if your company has adopted a lower limit) to a Limited-Purpose Health FSA. That's a total of $10,800 of compensation removed from your taxable income. At a 30% marginal tax rate, you save $3,240 in taxes (that's an additional $915 in tax savings from a maximum election to a Limited-Purpose Health FSA election).
2. You want to maximize your retirement savings. Every dollar of qualified dental and vision expenses that you reimburse from the Limited-Purpose Health FSA represents an additional dollar that you retain in your Health Savings Account to spend later - next month, next year, or in retirement.
3. You have scheduled expensive dental and vision expenses early in the new plan year. The Limited-Purpose Health FSA offers uniform coverage, described above, allowing you to tap into your full election early in the plan year. Health Savings Accounts don't have this feature (though your administrator may offer a different approach to advancing funds).
4. You plan to pay your non-dependent adult child's dental or vision expenses. As described above, you can reimburse these expenses from your Limited-Purpose Health FSA, but not your Health Savings Account.

When you pursue the two-account strategy, remember that your Health FSA election is binding and can be changed only with a qualifying life event, not a sudden dental, vision, or general financial need. You do have the flexibility to change your Health Savings Account contributions throughout the year as your needs change.

The Bottom Line

It can be confusing when an employer offers both a Health Savings Account and a Health FSA. That confusion is magnified when the company also sponsors a Limited-Purpose Health FSA. But when you understand how these plans work and apply them to your family's medical and financial situation, you can reap the benefits of some combination of lower taxes, immediate access to cash, and long-term savings for qualified health-related expenses.

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The content of this column is informational only. They are not intended, nor should the reader construe the content, as legal advice. Please consult your personal legal, tax, or financial counsel for information about how this information applies to you or your entity.