Take Advantage of Tax-Deferred Accounts for Health-Care Costs

Whether you're employed by a large corporation, a small company or you work for yourself, chances are you can funnel money through a special tax-deferred account that can save you one-third or more on your health care costs.

Your employer may let you contribute to a flexible spending account or health savings account, or you may be able to open an HSA on your own. Both accounts let you use tax-free money for medical expenses, but they each have very different rules.

Flexible spending accounts

In a flexible spending account, money is deducted from your paycheck on a pretax basis to pay for out-of-pocket expenses, such as insurance co-payments and deductibles, as well as for qualified medical costs that may not be covered by your health insurance plan -- for instance, orthodontia, elective surgery, eyeglasses and contact lenses. You can also use the money for out-of-pocket costs for prescription drugs, but you can no longer use the money for non-prescription medications.

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You can contribute up to $2,500 per year to an FSA.Contributions to an FSA are not subject to federal income or social security and medicare taxes. Funneling money through a plan can save you one-third or more on your health care costs.

The drawback is that any money committed to the plan but not spent by the end of the year may be forfeited. Companies are allowed to offer employees a grace period until March 15 to use the money or carry over $500 from year to the next. But they're not required to offer these options, so many employers still require employees to use FSA money by year-end.

The use-it-or-lose-it rules for flexible-spending accounts cut two ways. The entire amount you designate to your FSA is available starting January 1, even though your contributions are spread throughout the year. So if you use the whole amount then leave your job before the end of the year, your employer has to eat the difference.

Health savings accounts

Because insurance costs are so high, it makes sense for healthy individuals and families to go with a high deductible health insurance policy and stash the premium savings in a health savings account (HSA). These plans became available in 2004 and are available both for the self-employed and company employees.

To qualify for an HSA, you must purchase a health policy with an annual deductible of at least $1,300 for self-only coverage or $2,600 for a family. This policy must be your only health insurance and you are not eligible to make new contributions to an HSA if you've signed up for Medicare. Once the policy is in place, you may set up an HSA and contribute up to an amount that is indexed annually for inflation. You can contribute up to $3,350 if you have individual coverage or $6,650 if you have family coverage in 2015, plus up to $1,000 if you’re 55 or older anytime during the year. See IRS Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans for annual amounts.

Money you put into the account can be deducted on your tax return regardless of whether you itemize deductions. Earnings in the account grow untaxed, just as in a 401(k) or IRA. But unlike retirement plans, you can dip into an HSA at any age -- tax-free -- to pay for medical expenses, including your policy deductible and co-payments. You can also use the money tax-free for many charges that are not typically covered by health insurance, such as prescription drugs, vision and dental care and a portion of your long-term-care insurance premiums.

Unlike flexible spending accounts, HSAs allow unspent money to be rolled over from year to year. You will owe income tax on earnings if funds are used for non-health-care purposes, and a 20% penalty will be imposed on any nonqualified withdrawal before age 65.

You can't have an HSA if you use a flexible-spending account to pay health care costs with pretax dollars or if you have other medical coverage (say, through a spouse's policy). However, if your FSA restricts reimbursements to wellness care (such as annual physicals) and vision and dental care, you can have an HSA, too.

After age 65, any money that's left in the HSA may be withdrawn penalty-free for any purpose, but earnings not used to pay medical bills will be taxed.

For more information, see FAQs About Health Savings Account Answers.