Congress has passed quite a few laws in past years dealing with the payment of medical expenses. As the baby boomer generation ages, rising medical costs are becoming a real concern. Recently, Congress has created health reimbursement accounts (HRAs) and flexible spending accounts (FSAs). And with the recent passage of the Medicare Prescription Drug and Modernization Act of 2003, Congress created yet another plan, the health savings account (HSA).

HSAs are designed somewhat like an IRA. In effect, you can put away tax-sheltered dollars that can be used to pay out-of-pocket medical expenses, such as your doctor co-pays or any other medical expenses not otherwise covered by your insurance. HSAs primarily help those who have high-deductible medical insurance policies. When the medical bills that aren't covered by your insurance come due, you remove funds from your HSA until your medical insurance finally kicks in. The great thing is that contributions to an HSA are tax deductible, and distributions taken to pay qualified medical bills aren't taxed to you either.

HSA rules
Sadly, not everybody can have an HSA, since there are two primary restrictions: the amount of your contribution and your health insurance coverage. Every year you're allowed to contribute to an HSA the lesser of your insurance deductible or an amount set by law. For 2004, those amounts are $2,600 for singles and $5,150 for family coverage. Additionally, to contribute to an HAS, you also need to be covered by a high-deductible health plan.

If you are covering just yourself, your annual deductible must be at least $1,000. For family coverage, the annual deductible must be at least $2,000. Additionally, you can't be covered by Medicare or any other health insurance plan (except plans that cover long-term care, dental, vision, and certain other medical costs). And finally, you must be younger than 65 to open an HSA.

So let's look at an example of how these restrictions might work. Let's assume that you're a single person and your medical insurance deductible is $3,500. That being the case, your deductible contributions to an HSA would be $2,600 (the lesser of your deductible amount or the amount set by law). But, on the other hand, let's say your medical insurance deductible is $1,750. In that case, your deductible contribution to your HSA would also be $1,750.

But there is good news for those ages 55 and older. You are allowed an additional contribution limit ($500 for 2004 and rising in the future). So using the example above for a person age 55 or older, if the insurance deductible is $3,500, the allowable deduction would be $3,100 ($2,600 plus the $500 additional contribution allowable for those ages 55 and older).

The clear advantage
How do HSAs compare with other plans? Well, the major problem with FSAs or HRAs is that those plans need to be created in partnership with your employer. And if your employer doesn't maintain such a plan, you're prohibited from establishing one on your own. That's one of the terrific benefits about HSAs: You can have one regardless of your employer's participation. And, since HSAs are not dependent on your employer, they are portable, so you can take them from job to job. Additionally, you can accumulate funds in your HSA and invest those funds. And the investment earnings aren't taxed.

Like an IRA, if you take distributions from your HSA for non-qualified medical reasons, you'll be subject to taxes on those distributions. And, if you take those non-qualified distributions before you reach age 65, you'll get hit with an additional 10% penalty. Don't forget that you can carry over balances from one year to the next with an HSA, allowing you to build up a nice nest egg in your HSA account. With an FSA contribution, you must use it or you lose it annually. You can't carry an FSA balance over from one year to the next.

Setting up an HSA is really very simple. You must make sure that you have a qualified high-deductible medical insurance plan and then contact a qualified financial institution. Since these accounts are relatively new, not all financial services companies may have them established. So check with your bank, broker, or insurance professional. They will be able to quickly tell you if they will allow you to make a deductible HSA contribution. But also make sure that you select a reputable firm to invest your HSA contributions.

Since this is such a new law, there are also few guidelines about how HSA funds can be invested. HSA accounts weren't intended to be invested to play market swings. They were intended to help you cover health-care costs not covered by your health insurance plan. So make sure that your funds are invested safely and, to a degree, conservatively.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues. You can view the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though. The Motley Fool is all about investors writing for investors.