HSA vs. FSA – Differences and How to Choose

Written by Richard Barrington

Financial Expert

Edited by Kristin Marino

Managing Editor

With medical costs rising at twice the general rate of inflation. There are tax-advantaged tools that can help you save to meet these expenses, but it is important to understand the nature of those tools to get the best use out of them.

Two popular savings vehicles are flexible spending accounts (FSAs) and health savings accounts (HSAs). While they seem similar on the surface, they have some vital differences that affect how they should be used and invested.

What Is an FSA?

FSAs are available through many workplaces. They can help you pay for certain health care items with pre-tax money. You can pay for prescriptions, health insurance deductibles, and things your insurance may not cover, such as eyeglasses.

How do FSAs work?

If you have a flexible spending account, you will specify an amount out of every paycheck to go into your FSA. 

You can contribute up to $2,750 per year to an FSA. The money can be contributed directly from your paycheck before taxes, or you can deduct the contribution amount on your income tax return if you fund the account with after-tax money. The important point is that as long as you use the money for legitimate medical expenses, which include health care services, prescription drugs, and insulin, the money you put into an FSA is never subject to income tax.

The catch is that FSAs operate on a use-it-or-lose-it principle. If you don’t use the money you put into an FSA during the plan year, it will be forfeited. At most, some plans allow for a maximum of $500 to be carried forward for use during the subsequent plan year, but this is subject to the rules of your employer’s specific plan.

The bottom line is that because the money in an FSA must be used in the near term, you should limit what you put into an FSA to an amount you are pretty certain you will have to pay in medical expenses over the coming year.

What Is an HSA?

Like an FSA, a health savings account is an employer-sponsored benefit plan, but its usage is limited to people who participate in a high-deductible health plan (HDHP). An HDHP is health insurance with an annual deductible of $1,800 for individuals and $2,800 for family coverage. An HDHP’s total annual out-of-pocket expenses such as deductibles, copayments, and coinsurance can be as high as $7,000 for an individual or $14,000 for a family. 

As with an FSA, contributions to an HSA are tax exempt, but the important difference is that you do not have to use the money in an HSA within any specific time limit. This means you can accumulate money in an HSA indefinitely. Both your contributions to the HSA and any investment earnings on that money are tax-exempt as long as the money is ultimately used for legitimate medical expenses.

Not only can HSA contributions accumulate in the account over time, but they are subject to higher limits than FSA contributions. For 2018, you can contribute up to $3,600 if you have individual coverage in an HDHP, and up to $7,000 if you have family coverage. If you are aged 55 or over you can add another $1,000 to those limits.

What Is the Difference Between an HSA and an FSA?

The following table summarizes the distinctive features of HSAs and FSAs:

When to Use an HSA or an FSA

So if your employer offers both, how do you choose between an FSA and an HSA?

One factor is whether or not you regularly need health care beyond normal check-ups. If so, then an FSA might be the right choice for you. This would allow you to participate in a health insurance plan with a lower deductible, and your expectation of having health care expenses over the coming year means that the money is likely to be used up within the time limit.

In contrast, if you have no particular reason to expect major health care expenses over the next year, an HSA might make more sense. You can better afford to participate in a HDHP if you don’t expect to have much in the way of health care expenses, and the higher deductible should allow you to pay lower premiums. Because you can carryover money in an HSA indefinitely, you can enjoy the tax advantage of contributing money to it without worrying about when you have to use it.

Investment Implications

The fundamental difference in how FSAs and HSAs are designed to be used also dictates a difference in investment approach.

The use-it-or-lose it nature of an FSA means that the money should be kept liquid. This means investing it in a deposit account or cash-equivalent type of fund. In contrast, the ability to carry money over in an HSA means that some portion of your HSA can be put into long-term growth investments such as stocks.

In essence, you can think of an HSA as being available both to fund any immediate medical expenses that arise and as a way of augmenting your retirement savings. Since health care is an especially large expense in retirement, HSAs can be a good vehicle for accumulating money tax-free for future use. In fact, unlike money in a 401(k) plan, money in a HSA plan isn’t even taxed when you eventually access it as long as you use it for medical expenses.

So, enough money to cover your annual health insurance deductible should be kept liquid within your HSA. Then, balances you accumulate beyond that can be invested in growth instruments to help meet medical expenses in the future.

While an FSA is a good vehicle for saving money to meet short-term medical expenses, an HSA has the added dimension of allowing you to accumulate and invest money to meet long-term health care needs.