The Basics of Health Savings Accounts: Understand HSA contributions, withdrawals and tax benefits.

Established as part of the Medicare prescription drug legislation that was signed into law in 2003, health savings accounts (HSAs) are tax-advantaged medical savings accounts available to individuals who are also enrolled in high-deductible health plans (HDHPs). Many private industry employees in the U.S. have access to HSAs, according to the Bureau of Labor Statistics.

HSAs enable these individuals to save money on a pretax basis that they can use to pay for qualified, out-of-pocket medical expenses they incur as participants in an HDHP. Funds can be contributed to HSAs by employers and/or individuals themselves. In 2012, up to $3,100 may be contributed to individual HSAs, while the 2012 HSA annual contribution limit for families is $6,250.

Individuals’ HSA contributions can be made in one of two ways: via a payroll deduction, in which case the contributions go directly from an employer into the employee’s HSA before income taxes are taken out, or by the individual writing a check and depositing it into his or her account.The first option is generally preferable from a tax standpoint, because it enables you to contribute what are known as “pretax dollars” to your HSA. Not only will you pay less money in current income taxes, but the interest and earnings on money deposited into an HSA are also tax-free.  Regardless of age, money withdrawn must be used for qualified medical expenses to have the distribution be tax and penalty free.

In order to deposit money into an HSA via payroll deduction, your employer must offer what’s known as a salary reduction or cafeteria plan. If your employer doesn’t offer such a plan, or if you’re self-employed, you cannot make pretax contributions into an HSA.

But that doesn’t mean you can’t still take advantage of an HSA’s tax benefits. However, instead of enjoying the convenience of pretax contributions, you’ll have to deduct your HSA contributions on your federal income tax return.

The good news is that such after-tax HSA contributions qualify as what’s known as an “above the line” tax deduction. This means you don’t have to itemize deductions by filling out Form 1040, Schedule A, in order to claim the HSA deduction. Instead, you simply enter the amount of your HSA contributions for the year on the first page of your federal income tax return, and this amount is subtracted from your total income in the calculation of your adjusted gross income.

So, for example, if you contribute the full $3,100 to an HSA this year, you will enter this amount on line 25 of Form 1040. Along with other above-the-line deductions, it will then be subtracted from your total income (line 22) in the calculation of your adjusted gross income (line 37).

If you have a choice, it’s usually recommended that HSA contributions be made automatically via payroll deduction instead of by depositing a check into the account. Aside from the tax benefits and convenience, a payroll deduction also helps ensure that the contributions actually get made each month.

If you have to contribute manually, it’s easier to find an excuse not to deposit the check into your HSA – if you’re faced with an unexpected expense that month, for example, or if you simply decide to put the money toward something else.

For more information about HSAs, visit www.irs.gov, consult a tax advisor or contact us today.