One of the biggest financial challenges that people face is covering the high costs of their healthcare. Especially as people get older, healthcare costs tend to rise much faster than inflation. Having a nest egg set aside to cover some of your out-of-pocket health expenses is crucial.

Health savings accounts (HSAs) were designed to give people an incentive for setting money aside for future healthcare needs. Lawmakers created health savings accounts in 2003 to allow people to set money aside for their healthcare costs on a tax-favored basis. 

To contribute to an HSA, you need to have a high-deductible health plan (HDHP). Basically, an HSA is meant for those whose health insurance doesn't kick in until they've already borne a substantial part of the upfront cost. Your plan counts as an HDHP only if it has the following features:

  • Minimum deductibles are $1,400 for self-only coverage or $2,800 for family coverage for 2020. The minimum deductibles will remain the same in 2021.
  • Out-of-pocket maximums are $6,900 for self-only coverage or $13,800 for families in 2020. The maximums will increase to $7,000 for self-only coverage and $14,000 for families in 2021.

Contributions to an HSA are deductible on your taxes even if you don't itemize. The limits are: 

  • In 2020, you can contribute $3,550 for self-only insurance coverage or $7,100 for family coverage.
  • In 2021, the limits will increase to $3,600 for self-only and $7,200 for families.
  • If you're 55 or older, you're allowed a $1,000 catch-up contribution.
  • Once you're 65 and covered by Medicare, you can't make additional contributions.

Some employers also make contributions on employees' behalf, though the employer's and employee's combined contributions can't exceed the annual limit. If your employer gives you health coverage through an HDHP plan but doesn't offer an HSA in conjunction, you can set one up on your own through an HSA provider, such as HSA Bank, Fidelity, HealthEquity, or Optum.

Three letter blocks spelling HSA on three piles of coins.

Image source: Getty Images.

What is an HSA-eligible expense?

The IRS has a broad list of expenses related to medical, dental, and vision care that it considers qualified expenses. As long as you spend HSA funds on any of these IRS-approved expenses, your distributions are tax-free. 

One big advantage of HSAs is that you're allowed to use the money in your account for a lot of expenses regular insurance doesn't cover, including copays. You can use your HSA to pay for these expenses not only for yourself, but also for your spouse, your dependent children, and anyone else who counts as your dependent relative for tax purposes, provided that they're covered by an HDHP and aren't otherwise insured. 

List of HSA-eligible expenses

Any expense you incur before your HSA is established will not be considered qualified. State law determines when your HSA is officially established. In most states, if you became eligible for an HSA on Jan. 1, but your first payroll deposit doesn't go to your HSA administrator until Jan. 10, your HSA isn't considered established until Jan. 10.

Here are some common IRS-approved HSA-eligible expenses. Note that this list is not all-inclusive. Always check with your plan provider if you have questions about whether an expense is covered.

  • Abortion
  • Acne laser treatment
  • Acupuncture
  • Ambulance fees and emergency care
  • Artificial limbs
  • Birth control pills, injections, and devices, like IUDs
  • Blood pressure monitors
  • Body scans
  • Breast pumps and lactation supplies
  • Breast reconstruction surgery following cancer
  • Canes and walkers
  • Childbirth expenses, such as care from a midwife or obstetrician. Childbirth classes for the expectant mother are also eligible, but not for someone in a coaching role.
  • Chiropractic
  • Contact lenses and saline solution
  • Crutches
  • Dental care, including cleanings, sealants, fluoride treatments, X-rays, fillings, braces, extractions, and dentures
  • Diabetes supplies, such as blood sugar test kits and insulin, and education, including nutrition counseling
  • Eye exams
  • Eye surgery, including laser surgery
  • Eyeglasses, both prescription and reading glasses. Prescription sunglasses qualify, but over-the-counter sunglasses don't. Blue-light-blocking glasses also typically qualify.
  • Feminine hygiene products (new under the CARES Act)
  • First-aid kits
  • Flu shots
  • Guide dogs to assist with disabilities. The cost of the dog, food, grooming, and veterinary care are all considered qualifying expenses.
  • Hearing aids and batteries
  • Hospital expenses, for both in-patient and out-patient services
  • Infertility treatment, including costs for in vitro fertilization; egg, sperm, and embryo storage; fertility monitors; sperm washing; and egg donor expenses
  • Inpatient drug and alcohol treatment 
  • Insulin
  • Lab fees
  • Long-term-care premiums, up to a qualifying amount based on your age at the end of the tax year
  • Medical alert bracelets
  • Medical records charges
  • Medicare premiums if you're 65 or older. However, you can't use your HSA to pay for Medicare supplemental policies, often referred to as Medigap policies.
  • Nightguards to treat teeth grinding
  • Nursing care, whether provided in the home or in a nursing home
  • Occupational therapy
  • Over-the-counter medications (new under the CARES Act)
  • Oxygen and oxygen equipment
  • Physical exams
  • Physical therapy
  • Prescription medications
  • Psychiatrist care
  • Psychologist care
  • Smoking-cessation programs and drugs, including nicotine patches and gums
  • Speech therapy
  • Surgery, but not elective cosmetic surgery. Anesthesiology costs also qualify.
  • Thermometers
  • Tubal ligation (female sterilization) and tubal ligation reversal
  • Ultrasounds
  • Vaccines
  • Vasectomy (male sterilization) and vasectomy reversal
  • Wheelchairs
  • X-rays

Expenses that may be HSA eligible with a diagnosis

The following expenses may be allowed under the IRS rules if you have a doctor's note that says they're necessary to treat a medical condition. Whenever you do have an expense that requires a diagnosis, be sure to keep careful documentation from your provider. 

  • Breast implant removal, if the implant is defective or causing medical problems
  • Car costs for additional features for someone with a disability, like hand controls or a wheelchair lift
  • CBD and hemp oil
  • Cosmetic procedures, if they're used to correct a deformity or scar stemming from an injury or disease
  • Electric toothbrushes may be reimbursable if you have a diagnosis, but the replacement brushes are not.
  • Fluoride toothpaste and rinses
  • Home improvements to accommodate a medical condition. For example, the costs of widening a doorway or adding a ramp to make the home accessible for someone in a wheelchair would be qualified.
  • Massage therapy and chairs
  • Mattresses, mattress boards, and special cushions and pillows
  • Meals and lodging, if the costs are incurred during medical treatment
  • Special clothing may be covered if it's used to provide relief from a diagnosed condition, but only the amount above regular clothing costs will be eligible.
  • Special education or tutoring services for someone with a learning disability
  • Special home modifications for someone with an intellectual or physical disability. The costs will qualify only if it's not the home of a relative.
  • Vitamins and dietary supplements
  • Weight-loss programs, health club dues, and exercise equipment
  • Wigs, if you lost your hair due to a disease

If you need items or services you don't see listed here, you can search the HSAstore for your exact need.

New HSA-eligible expenses for 2020 and 2021

Previously many OTC medications and products were HSA eligible only with a prescription. Under the CARES Act, which passed in March 2020, you can now use your HSA card to pay for a variety of OTC items without a prescription. The rules are retroactive to Jan. 1, 2020, so if you purchased these items with non-HSA funds, you can still submit your receipts for reimbursement. 

Telemedicine or remote healthcare can be covered by HSA plans at no charge, even if you haven't met your deductible, through the end of 2021.

The following items have also been made HSA eligible by the 2020 CARES Act:

  • Acid reducers
  • Acne treatment
  • Allergy and sinus medications
  • Anti-allergy medications
  • Breathing strips
  • Cough, cold, and flu medications
  • Eye drops
  • Feminine hygiene products, like pads, tampons, and menstrual cups
  • Heartburn medications
  • Insect repellant and anti-itch creams
  • Laxatives
  • Lip treatments for cold and canker sores
  • Medicated shampoos and soaps
  • Nasal sprays
  • Pain relievers
  • Skin creams and ointments, including cleansers, toners, and moisturizers
  • Sleep aids
  • Sunscreen and OTC remedies (like aloe gel) to treat the effects of sun exposure

HSA-ineligible expenses

The penalties for using your HSA for nonqualifying expenses are steep. Ineligible distributions will be considered taxable income; plus, you'll be hit with a 20% penalty if you're under 65. Once you're 65 or older, you can avoid the 20% fine, but you'll still owe income taxes for nonmedical withdrawals.

The IRS typically won't allow you to use your HSA for the following expenses:

  • Child care for a healthy child
  • Cosmetic procedures, unless they're used to correct a deformity or treat an underlying medical condition. Breast enhancement, electrolysis, face lifts, and hair removal generally won't be covered.
  • Employment-related physicals
  • Funeral expenses
  • Health insurance premiums, unless you have COBRA continuation coverage or you're receiving unemployment benefits
  • Imported medications that aren't FDA approved
  • Infant formula, even when the mother can't breastfeed
  • Late charges and missed appointment fees
  • Life insurance premiums
  • Long-term disability premiums
  • Marijuana, even if it's prescribed by a doctor
  • Maternity clothes
  • Toiletries

FSA- vs. HSA-eligible expenses

Both an HSA and a flexible spending account (FSA) give you a tax-advantaged vehicle to set money aside for medical expenses. The key difference isn't which expenses are covered. It's who controls the money in the account. 

An HSA is like a 401(k) plan in that you own the money in the account. It's yours to take with you if you leave your employer. Any funds you don't spend one year roll over to the next, and you can even invest your contributions without paying taxes on the earnings.

By contrast, you can contribute to an FSA only if your employer offers one, and the employer owns the account. If you leave your job for any reason, you'll usually forfeit the money. The funds are also "use it or lose it." The maximum amount your employer can allow you to roll over from one year to the next is $500.

Typically you can't contribute to an HSA and an FSA at the same time unless you have an HSA-compatible FSA. Also referred to as a limited-purpose FSA, this type of account can be used only for qualified dental and vision expenses. Sometimes using a limited-purpose FSA for these expenses makes sense if you have high medical bills or if you're trying to max out your HSA while limiting your distributions. The restrictions exist because both accounts are tax advantaged and are used for similar expenses.

Is funding an HSA a good idea?

An HDHP that you supplement with an HSA can be great for those who are relatively healthy and don't have a lot of medical costs. But for those who have current medical conditions requiring ongoing treatment, HDHPs can be expensive.

If you expect to incur major medical bills -- for example, if you know you need surgery or you're planning to start a family -- a traditional insurance plan will be better suited to your healthcare needs. But if you don't expect any big expenses, an HSA can be a great way to save for future expenses and supplement your retirement savings.