About three years have gone by since health savings accounts (HSAs) first became available, and an estimated 4.5 million Americans have opened them. But to many people, HSAs remain something of a mystery. Sometimes described as a 401(k) for medical expenses, an HSA is a tax-favored account that can be used to pay out-of-pocket medical expenses.

Required coverage.

To be eligible for tax-favored contributions to an HSA, an individual has to be covered under a “high deductible health plan” (HDHP) and generally can’t have other health coverage. For 2008, the plan’s deductible must be at least $1,100 (self-only coverage) or $2,200 (family coverage). But the annual deductible plus any other out-of-pocket expenses payable under the plan (not including premiums) cannot exceed $5,600 (self-only coverage) or $11,200 (family coverage).  HSA Insider offers an Insurance Quote feature that will list Insurance Agencies that provide HDHPs that meet the qualifications for HSA Accounts.

Contributions.

Within limits, HSA contributions are tax deductible. Alternatively, if the HSA is offered through an employer’s cafeteria plan, the plan can allow employees to make paycheck contributions on a pretax basis.

In 2008, a maximum contribution of $2,900 is generally allowed ($5,800 for those with family coverage). Individuals age 55 and older can make additional catch-up contributions. The 2008 catch-up limit is $900.

Earnings.

All earnings on HSA investments accumulate on a tax-deferred basis.

Withdrawals.

HSA withdrawals used to pay qualified medical expenses are free of federal income tax. Withdrawals not used for qualified expenses are taxable. A 10% penalty will also apply to nonqualified withdrawals unless they are made after the account beneficiary’s disability or death or after the beneficiary has reached the age for Medicare coverage.

More Information.