Saving for medical costs: FSA, HSA, or both?

Shelly Gigante

By Shelly Gigante
Shelly Gigante specializes in personal finance issues. Her work has appeared in a variety of publications and news websites.
Posted on Nov 15, 2021

Medical bills can take a bite out of your budget — even if you have health insurance — so it’s no surprise that pretax savings vehicles such as flexible spending accounts (FSAs) and health savings accounts (HSAs) are an attractive option for many.

Savings in these accounts directly reduce your taxable income, and the money can be used to pay for unreimbursed health care expenses. In the case of a FSA, you may also be able to use tax-advantaged income to pay for qualifying day care expenses for children and adult dependents.

While FSAs and HSAs can both help you cover the cost of care, however, the rules that govern them — including who is eligible to contribute and when your savings must be used — differ greatly.

Before you elect an FSA or HSA during open enrollment with your employer, it is important to determine which account, or whether a combination of both accounts, might work best for you.

Flexible spending accounts

An FSA, which can only be opened through an employer's benefit plan, allows you to set aside pretax income to pay for eligible medical or dependent care expenses not covered by your insurance plan for yourself, your spouse, and any qualifying dependents.

Your contributions to an FSA are automatically deducted pretax each month from your paycheck, which saves you the equivalent of your tax rate. According to the federal government, FSA participants save an average of 30 percent on qualified expenses.

The federal government’s online calculator can help you determine how much you can potentially save each year by contributing to an FSA based on your marginal federal and state tax rates.

There are three types of FSAs:

  • A general purpose health care FSA, which can be used to pay for out-of-pocket medical, dental, and vision care expenses not covered by your insurance plan. That typically includes copays, co-insurance, deductibles, prescription drugs, eligible over-the-counter medications, and medical supplies.
  • A limited expense health care FSA, which is only available to those who also have an HSA through a high-deductible health plan. These FSAs limit your reimbursement to vision and dental expenses. The Internal Revenue Service does not permit taxpayers to enroll in a general purpose health care FSA and an HSA at the same time.
  • A dependent care FSA, which can be used to reimburse yourself for eligible dependent care services, such as preschool, summer day camp, before-or-after school programs, and child or adult day care.

The 2022 annual contribution limit for a general purpose and a limited expense health care FSA is $2,850, up from $2,750 in 2021. Absent congressional action, the 2022 dependent care FSA contribution limit for families reverts back to $5,000. It was temporarily raised to $10,500 in 2021 for single taxpayers and married couples filing jointly, and $5,250 for married individuals filing separately as a pandemic relief measure.1,2

You may change your FSA contribution amount once each year during your employer’s open enrollment period. After that, the window to change your contribution closes until the open enrollment period of the following year.

You may, however, be permitted to change your contribution election midyear if you experience a qualifying event, including a change in marital status, the birth or adoption of a child, a change in employment, or a change of residence. All require supporting documentation.

FSA drawbacks

Historically, the biggest drawback to FSAs has been their “use it or lose” feature, requiring account owners to forfeit any savings not used for qualified expenses each year by December 31. But many employers have recently adopted new provisions that allow for greater leniency.

Some now permit workers to carry over up to $550 of the funds in their general purpose FSA to the following year’s allocation, and others are extending their employee’s FSA benefit period for up to 2.5 months into the new year, providing employees with more time to incur new expenses and spend down their account.

Due to challenges stemming from the COVID-19 pandemic, the IRS also granted employers permission to allow their workers to carry over their entire unused balance for plan years ending in 2021 and 2022.

Note that employers are not required to offer carryovers or a grace period of any kind.

Regardless of your employer’s FSA policies, you’ll want to run some projections before you select a contribution amount, keeping in mind that that your contribution amount may fluctuate every year.

Start by adding up your out-of-pocket eligible expenses from last year.

If you spent more than the contribution limit, and you’re likely to do so again in the coming year, consider maxing out your FSA next year. If you spent less than the contribution limit, and you’re likely to do so again this year, you’ll need to do some math to determine how much of your income you should allocate to your FSA next year.

It’s all about assessing your current health needs and any procedures or projected dependent care expenses you are likely to incur in the coming year, said George Ossi, a financial professional with Coastal Wealth Management in St. Augustine, Florida.

“If one spends, for example, on average $1,000 per year for out of pocket for medical, dental, and vision expenses, that's a good way to do an estimation,” he said. “If there is an expectation to spend more in a given year—for example, upcoming labor and delivery—one might choose to elect the current FSA maximum of $2,750 in that year.”

Health savings accounts (HSA)

An HSA, by contrast, is a pretax savings account that can be opened through either an employer or a private insurer. Thus, they can be opened by the self-employed. (Related: Freelancer benefit checklist)

But they are only available to those who have a qualified high-deductible health plan.

The HSA contribution limit for 2022 increases by $50 to $3,650 for individuals and by $100 to $7,300 for families.3 Those 55 or older can make an additional $1,000 catch-up contribution.

The rules for HSA contributions are less restrictive than they are for FSAs. You may change your contribution amount to an HSA at any time throughout the year, for any reason, as long as you do not exceed the annual limit.

Another important way that HSAs differ from FSAs is that your contributions need not be depleted by the end of each year. Your savings are allowed to accumulate. In many cases, you can also invest a portion of your contributions in an investment portfolio for growth.

Once you turn age 65, those savings can be used tax free to pay for qualified medical expenses.

HSA savings

For that reason, financial professionals say those who can afford to max out their HSA contributions and pay out of pocket for unreimbursed health care costs today stand to benefit the most. They get the upfront tax deduction for their contribution, their withdraws are tax free if used for eligible expenses, and their savings generate tax-free growth. (Learn more: Health savings accounts for retirement planning: Pros and cons)

“Medical, dental, and vision expenses tend to go up as people get older,” said Ossi. “Financial security is critical for fending off future health care costs. The HSA is an accumulation asset that is tax advantaged and designed to cover those expenses. It can potentially grow to a significant value, providing security for unexpected future medical expenses.”

That said, HSAs and FSAs are not ideal for everyone. “Individuals with costly chronic medical conditions might better be served by a traditional copay medical plan with limited deductibles and out-of-pocket maximums,” said Ossi. “Also, individuals with more limited incomes might not realize a significant tax savings by having either an HSA or FSA.”

Combining the HSA and FSA

With higher contribution limits and the ability to accumulate savings for future use, the HSA is often considered to be the more tax-friendly tool.

To help maximize pretax savings, some employers offer both an FSA and HSA. In that case, you would need to enroll in their qualifying high-deductible health plan to be eligible for the HSA, and you would have to select the limited expense FSA, which restricts your reimbursement to dental and vision care.

This strategy is ideal for households with slightly higher medical expenses than average. It may also make sense for those who wish to offset a portion of their annual unreimbursed health and dependent care expenses today (by using their FSA), but also accumulate savings for medical costs in retirement via their HSA.

The other potential benefit of a combined FSA and HSA is access to savings. With an FSA, you have access to your annual contribution election on day one. With an HSA, you only have access to your funds as they accumulate. Thus, an FSA gives your HSA balance time to build.

Conclusion

The FSA and HSA are valuable pretax tools for managing health care and dependent care expenses. To determine which best meets your family’s financial needs, it is important to review the contribution limits, project your expenses, and perhaps consult a financial professional for guidance.

Discover more from MassMutual…

Want tax savings in retirement? Consider an HSA

Health savings accounts for retirement planning: Pros and cons

Need a financial professional? Find one here

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Society for Human Resource Management, “IRS Guidance Clarifies Taxability of Dependent Care FSAs Through 2022,” May 25, 2021.

2 Internal Revenue Service, “Taxation of Dependent Care Benefits Available Pursuant to an Extended Claims Period or Carryover: Notice 2021-26.”

Newfront, “IRS Issues 2021 Dependent Care FSA Increase Guidance and 2022 HSA Limits,” May 11, 2021.

The information provided is not written or intended as specific tax or legal advice. MassMutual, its subsidiaries, employees and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from your own tax or legal counsel. Opinions expressed by those interviewed are their own and do not necessarily represent the views of Massachusetts Mutual Life Insurance Company.