HSA vs. FSA: What You Need To Know as an Advisor

Similar, but at the same time, oh-so-different—what really is the difference between a HSA and a FSA, and when is it best to choose one over the other? The XY Tax Solutions Team came together to highlight the pros and cons of each, what's covered, what's not covered, and of course, the lowdown on how each can help to reduce your tax liability. Let's dive in.

Health Savings Account (HSA)

Health Savings Accounts are an effective and frequently underutilized tax-advantaged savings account. Eligible individuals that are covered by a qualified high deductible healthcare plan (HDHP) can contribute funds into a tax-free and interest-bearing trust or custodial account. These individuals must either be a recipient of an employer health coverage plan or hold their own qualified HDHP.

While your eligibility for an HSA is dependent on your health plan, eligible individuals are effective owners of the account because they are the trustee and may take their account with them if they were to change jobs or health plans. Such autonomy provides assurance that your contributions are not subject to forfeiture, seizure, or any other similar infringement. If your employer does not offer a HSA and you are eligible, don’t sweat—most banks and credit unions also offer HSAs. So, is it right for you? Let’s get into the details and find out.

Tax Advantages

HSA contributions are made with pre-tax dollars, while qualified distributions are tax-exempt. Similarly, after-tax contributions to an HSA are tax-deductible. The interest earned in this account is also nontaxable. Furthermore, contributions that are made by your employer are not included in your gross income. With an assortment of desirable tax benefits, these savings accounts can be leveraged in very substantial and favorable ways.

These tax savings are often referred to as a triple tax advantage because:

1. Contributions are not taxed 
2. Interest and investment earnings if held within a brokerage are not taxed and 
3. Qualified medical expenses are not taxed!

Understanding the related limitations and provisions will be critical in order to make proper use of such a tax-exempt, wealth-building opportunity. HSA distributions are not taxable so long as they are being spent on qualified medical expenses. Such expenses include (but are not limited to) what's listed below.

What can your Health Savings Account cover?

It is worth noting that the Coronavirus Aid, Relief, and Economic Security (CARES) Act has expanded upon the assortment of qualified medical expenses. Coronavirus-related personal protective items such as face masks, hand sanitizer, and sanitizing wipes are newly qualified medical expenses. Additionally, the CARES Act supplemented the index of qualified medical expenses with non-Coronavirus-related items such as over-the-counter medications.

How much can be contributed?

In 2022, there is a $3,650 annual contribution limit for individuals, while a family-covered plan has a $7,300 annual limit. 55+-year-old HSA owners are also permitted an additional $1,000 in catch-up contributions. Here is a piece of good news: 2021 contributions can be made up until April 18th, 2022 (as long as the HSA was opened before year-end)! If an HSA account was not open prior to January 1st, 2022, then contributions can only be classified as being made within the 2022 tax year.

In the event of excess contributions, there are multiple options available for the taxpayer. The individual can either:

1. Withdraw the excess contributions and pay taxes on the net income that is attributable to those excess amounts.
2. Pay a 6% excise tax on the excess contributions that remain within the HSA. If the individual leaves their excess contributions within their HSA, then the 6% excise tax is incurred every year until it is removed or applied to a future year. 

While the nature and source of these contributions are largely irrelevant, the nature of HSA distributions is a far more complex issue. HSA distributions used towards non-qualified expenses trigger a taxable event along with a 20% penalty. These deterrents are entirely avoidable as long as you are diligent and mindful of how you utilize your funds; there are no deterrents against qualified medical expenses, as mentioned above. Similarly, there is no penalty for any unused HSA funds on a year-to-year basis, as all funds roll over indefinitely.

If you are worried about contributing more money to your HSA than would be used, no worries, consider your HSA distributions to be similar to that of a traditional IRA. Once you’re 65+ years old, any withdrawals for non-qualified expenses will simply be subject to regular income taxes (and no 20% penalty!).

Flexible Spending Account (FSA)

Flexible spending accounts/arrangements (FSA) are tax-advantaged saving accounts that are only available from an employer. These accounts are owned by your employer and are typically offered as part of a cafeteria plan at the beginning of employment and at the beginning of each plan year. You do not need a qualifying health plan to contribute, but individuals and those who are self-employed cannot open an FSA on their own.

The FSA is generally pre-funded with the entire annual amount available at the beginning of the year, allowing you to be reimbursed for qualified expenses early into the year. Contributions to cover the funded amount are taken directly from each paycheck as pre-tax income based on the amount selected during enrollment. The amount to be contributed cannot change unless your family situation or employment status changes. Furthermore, all funds in the FSA are forfeited if you leave your job (with the exception of FSA continuation through COBRA). 

Tax Advantages

Contributions into the FSA can only be withdrawn to pay for qualified medical expenses, including prescriptions, deductibles, copayments, etc. Typically, employers provide debit cards that can directly access the fund to employees who have an FSA or employees are reimbursed for qualifying expenses.

These contributions are made directly from the employee’s paycheck with pre-tax dollars, and funds used for qualifying expenses are withdrawn tax-free. Additionally, any reimbursements for qualified expenses are made tax-free. However, unlike the HSA, FSA money cannot be invested and does not bear any interest.

What's covered?

The three most common types of FSA that are offered by employers are:

• Health FSA
• Dependent care FSA 
• Limited purpose FSA.  

Each FSA follows the general rules (above) and can cover expenses that are not covered by a HSA.

Health FSA covers qualified medical expenses similar to that of an HSA. It is important to note that an individual cannot have both a health FSA and a HSA at the same time.

Dependent care FSAs can cover expenses for dependent care and the costs for children up to the age of 14, including daycare, summer camps, nursery and preschool, dependent-related housekeeping expenses, and more. If you have a dependent care FSA, you must file Form 2441 with your return. A dependent care FSA is compatible with a HSA.

A limited-purpose FSA is an account that is also compatible with a HSA and is often used to take advantage of both tax-free saving accounts. A limited-purpose FSA can only be used to pay for eligible vision and dental care expenses. This includes related deductibles, co-pays, co-insurance, exams and diagnostic services, and more. 

How much can be contributed?

• The 2022 annual contribution limit for individuals with a health FSA is $2,850; if employers offer a FSA to both spouses, the household has an annual limit totaling $5,700. 
• For 2022, individuals with a dependent care FSA can set aside up to $5,000 a year per family or $2,500 a year for a married person filing separately.
• A limited-purpose FSA has a contribution limit of $2,850 for the employee and does not change with more dependents. 

The general rule for a FSA is that the contributions are “use or lose,” meaning you lose the contributions that are not spent at the end of the year; however, some plans offer a carryover of $570 to the following year. If your employer’s health plan includes a grace period, then under the IRS guidelines, you are allowed a period of two and a half months to make use of funds from the previous year’s contributions.

In response to the recent pandemic, participating employees of FSA are more likely to have unused funds in their accounts. Under the Taxpayer Certainty and Disaster Tax Relief Act of 2020, the IRS expanded the flexibility of the health FSA regarding carryover and special rules and periods. In 2020 and 2021, the full amount was allowed for carryover for the following year (or a grace period of 12 months). This means that the 2020 funds could be carried over to 2021, and 2021 funds could be carried over to 2022.

Quick Comparison 

* ($570 only), 2020 & 2021 tax years: a carry-over allowed to the following year. (Unused from 2020 can carry over to 2021, and 2021 unused can carry over to 2022)

** limit for health FSA

HSA vs. FSA

Choosing a high deductible healthcare plan (HDHP) is generally cringed at! Especially when looking at the possibility of high deductibles compared to insurance plans that come with low copays—but with lower copays, those plans also come with a higher monthly premium. In electing to have a HDHP that offers an HSA not only will the individual use their income for the expenses, but they will be doing so in a way that lessens their gross income (employer contributions), possibly dropping them into a lower tax bracket and that is where a big a tax savings could occur.

The triple tax advantage is the other way that individuals can come out ahead in choosing a HDHP over a low deductible plan. This is also a way to maximize contributions for retirement. If you are already maxing out your IRA contribution of $6,000 and want to do more then this is a good choice. A consideration for estate planning, though would be that the account is able to be transferred to your spouse if they are designated as the beneficiary, but if your spouse is not the beneficiary the account is no longer considered an HSA, and the fair market value is taxable.

HSA and FSA both provide tax advantages and should be utilized by individuals in the right circumstances. The dependent care FSA is a big win for many parents that know their childcare costs ahead of time. Although FSAs are a great advantage if it is offered, especially for routine and anticipated medical events. However, unforeseen events could happen. For example, non-routine medical events could easily go over your contribution amount.

Another consideration that should not go without mentioning is that many individuals that used the dependent care FSA forfeited their balances when COVID happened because children stayed at home instead of going to daycare or camp. This was a big blow financially. Despite the advantages of a FSA, since these events do occur, one needs to weigh their individual pros and cons to determine if an FSA would be the best in their situation. 

The takeaway

Both HSAs and FSAs have their own disadvantages and advantages when it comes to tax savings and beyond. Which one you choose or advise your client to choose depends on the unique considerations of each situation. A trusty tax professional can help you make the right decision when it comes down to reducing your tax liability, but personal preference also plays a role in which option will be best.

Hungry for more tax topics? We get it! Learn the A-Z on how to integrate tax prep and planning into your service model in this on-demand (free) webinar.

About the Authors

Danelle Kruszka is a Tax Intern on Team XY Tax Solutions. Her favorite part about her job is the stellar team that she works with and she finds the positive work environment to be contagious. When Danelle’s not knee-deep in tax returns, you can find her outside—she enjoys gardening and hiking in her free time.

Avery Heinz is a Tax Intern on Team XY Tax Solutions, and he loves gaining new tax-related knowledge in his role every day. Avery loves to cook in his free time, is a self-proclaimed major basketball fanatic, and also spends time with his Miniature Schnauzer named Tyson. As a fun fact, Avery has also worked as a Bookkeeping Intern on team XY Bean Counters, and this is his second internship with XY Tax Solutions.

Ryan Chan is a Tax Intern on Team XY Tax Solutions. His favorite part about his job is deepening his understanding of tax prep and XYTS processes. When he’s not busy working in the tax world, he doesn’t stray too far! He enjoys investing and budgeting in his free time.