Although health savings accounts, known as HSAs for short, are considered one of the best investment choices available, many people know little or nothing about them. HSAs can be better than 401(k)s, IRAs, and even Roth IRAs.

Perhaps it isn't well known due to its name. Perhaps some people view it as more of an insurance policy. Regardless of the reason, if you are eligible to have one, it is wise to learn more about what these little-known investment accounts entail. It can have a significant financial impact on you and your family for years to come.

What Are Health Savings Accounts?

Although a 401(k) or IRA account can offer a reduction on your taxes without incurring taxes over the years, you still pay income tax on any distributions you take to fund your years of retirement. Roth IRAs do not offer reductions on current taxes, but any distributions taken at retirement are tax-free. Health savings accounts offer triple tax benefits: contributions are tax deductible, the funds are tax-free upon withdrawal (if managed appropriately), and your earnings can grow tax-free over the years.

Who Is Eligible?

A health savings account is intended to help individuals set aside money to cover health care expenses. Unfortunately, some people do not qualify for an HSA account. To be eligible, you need to be enrolled in an HDHP (high-deductible health plan). In 2017, HDHP plans are defined by having a minimum of $1,300 deductible for an individual and $2,600 for a family. The plan is also required to limit co-pays and other out-of-pocket expenses to $6,550 per individual and $13,100 per family. 

How Much Are You Allowed to Contribute?

2017 rules dictate that $3,400 is the maximum contribution for an individual, while families can contribute 56,750. Individuals over the age of 55 are allowed to put in "catch up" contributions of $1,000 on a monthly basis. They can also make lump sum contributions for the prior year up until the tax return deadline, typically April 15. If your health insurance is through your employer and is an HDHP, your contributions can be made through payroll deduction. Some employers even offer contribution matching as a benefit. Be aware that you are no longer allowed to make contributions once you are 65 and enroll in Medicare.

Tax Rules

In terms of HSAs, the most crucial aspect to understand is that any distributions you receive are only tax-free if you spend the funds on eligible medical expenses. These distributions can be made on yourself, your dependents, or your spouse. If you choose to take a distribution and use it for nonqualified expenses, this amount is considered taxable income. It is also subject to a 20% penalty tax. Once you hit age 65, this penalty goes away.

Any time you find yourself facing eligible medical expenses, you are qualified to make distributions. However, a popular strategy that many individuals employ is paying for day-to-day medicals costs right out of pocket to allow their HSA to grow. For the majority of individuals, medical expenses become a more significant part of the budget as they get older. This strategy lets individuals accumulate tax-free funds that can be used to cover these expenses.

Common Misunderstanding Surrounding HSAs

Perhaps one of the reasons HSAs are undervalued is due to the misconceptions that are associated with them. Many people confuse them with flexible spending accounts, known as FSAs for short. People typically contribute to FSAs through payroll deduction. These funds can then be used to cover eligible medical expenses during the year. However, these funds are considered "use them or lose them" since they disappear if they aren't used by the end of the year. HSA funds, on the other hand, do not expire.

People also assume that HSA accounts are only available through an employer. However, the truth is, you are qualified to contribute as an individual is you have an eligible HDHP.

The Takeaway

Although there are specific rules you must understand and follow in order to enjoy all the benefits of these tax-free accounts, if you are qualified, these accounts can have a huge impact on your financial future.