Health savings accounts and flexible spending accounts are two forms of tax-beneficial plans for payment of qualified medical expenses allowed under the Internal Revenue Code in the U.S. Although both forms of plans allow taxpayers to pay for certain medical costs on a pre-tax basis, the plans differ substantially.
Flexible Spending Accounts -- General
Flexible spending accounts are the individual employee accounts of flexible spending arrangements, plans developed for employees by employers and governed under Section 125 of the Internal Revenue Code. Amounts contributed to flexible spending accounts are not taxed for federal income tax purpose or for purposes of Medicare or Social Security taxation. Employees may then use all funds in the account for any qualified medical expenses approved by the Internal Revenue Service.
Health Savings Accounts -- General
Health savings accounts are medical savings accounts where the participant may make annual contributions up to a preset annual limit. The contributions are deductible for federal income tax purposes, although unless made through a qualifying employer plan, they are taxed for Medicare and Social Security purposes. Investments in the account grow tax-free. Account holders may then withdrawal amounts in the account tax-free for any qualifying medical expense. Non-qualified withdrawals are subject to a 10 percent penalty, although this penalty is waived for those 65 or older.
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Not all taxpayers are eligible for these plans. Taxpayers may only participate in a flexible spending arrangement if their employer has established and maintains a formal plan under Section 125 of the Internal Revenue Code. Because of the complexity of these plans, many very small employers will not establish them. Only taxpayers enrolled in a high-deductible health plan, an insurance plan, are eligible to participate in health savings plans. Because of high out-of-pocket costs often incurred in HDHPs, these are unattractive to many taxpayers.
Use of Funds
Both flexible spending accounts and health savings accounts allow account holders to use funds within the account for any qualified medical expense. Flexible spending accounts may also be established for dependent care costs. Funds contributed to flexible spending accounts, however, must be used within two and a half months of the year in which they were contributed. If not used in this time period, the funds are lost to the account holder. Health savings accounts have no such limitations on usage.