A health savings account (HSA) is an account that allows the holder to receive distributions tax-free for medical expenses. These accounts are designed to pay or reimburse medical expenses; you may receive distributions for other reasons, but you will be penalized for doing so.
An HSA is a tax-exempt trust or custodial account that is created for the purpose of paying certain medical expenses. The trust or custodial account must meet certain requirements imposed by the Internal Revenue Code. Only one person may be the account holder of an HSA and the account holder owns that account. HSAs may be funded by employer contributions or contributions from the account holder.
To be eligible to have an HSA, you must be covered under a high deductible health plan, generally with no other health coverage. For 2010, a high deductible health plan is a health plan that has an annual deductible not less than $1,200 for self-only coverage and $2,400 for family coverage and has an out-of-pocket limit equal to $5,950 for self-only coverage and $11,900 for family coverage. You may not be enrolled in Medicare and no one else can claim you as a dependent on their tax return.
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Withdrawals or distributions from your HSA are generally tax-free. In order to receive the tax-preferred distribution, you must use your HSA to pay or reimburse you for your qualified medical expenses. In general, qualified medical expenses are those expenses that qualify for medical expenses deduction. The IRS defines those expenses as "the costs of diagnosis, cure, mitigation, treatment or prevention of disease, and the costs for treatments affecting any part or function of the body." Expenses that are simply beneficial to general health, such as a vitamin, do not constitute qualified medical expenses.
Federal law provides that an HSA may not limit the account holder's ability to take distributions for any purpose. However, distributions made from an HSA for non-medical reasons are subject to income tax as they're included in the account holder's gross income. Moreover, the account holder will be subject to a 10 percent penalty on the non-medical distribution.
The account holder actually owns the HSA; therefore, the account is portable between the account holder's jobs. No use-it-or-lose-it rules are associated with an HSA.