The HSA-Health FSA Debate: Is One Better Than the Other?

They are two distinct approaches to addressing the same point. Is one better than the other? Is it an either/or choice?

You have a choice of paying for qualified medical, dental, and vision expenses through a Health FSA or a Health Savings Account. Congratulations! Many employers offer one or the other, but not both. Many workers qualify for only one, even when their company offers both. And workers in non-traditional roles (e.g., they don't meet the federal definition of employee) have access to, at most, one.

Thus, the question of which account is better affects only a subset of the adult population. Let's look at who's eligible for which plan and what to consider if you can participate in either.

Eligibility

People often don't have a choice of enrolling in a Health FSA or owning a Health Savings Account, so the comparison is moot (although good to know if the option to participate in the other program appears in the future).

Health FSAs are employer-sponsored accounts. Thus, only eligible employees of companies that offer a Health FSA can participate. This rule excludes employees of companies that don't offer the plan (usually very small employers or companies with high employee turnover), employees not eligible for benefits (like part-time workers), the self-employed, and gig workers.

Health Savings Accounts aren't employer-sponsored, so the excluded people listed above may be able to participate. But eligibility rests in part on enrollment in an HSA-qualified medical plan. And many employers don't offer this option.

Time Horizon

Health FSAs allow participants to reimburse qualified medical, dental, vision, and over-the-counter services and items with pre-tax dollars. Because they are an employer-sponsored plan, Health FSAs have a plan year (always 12 months unless the company makes a one-time adjustment to its anniversary date with a short plan year). Under Cafeteria Plan rules (which govern Health FSAs), funds can't carry over indefinitely. In recent years, changes to the law allow employers to add a grace period (an additional two and a half months to spend a plan-year balance) or a carryover of a limited amount (20% of the plan's maximum election) into the following plan year. But participants can't use a Health FSA to save for expenses far into the future.

In contrast, Health Savings Accounts are not time-bound. They offer the same tax benefits (tax-free contributions, growth, and withdrawals for qualified expenses), but participants can accumulate balances over time to reimburse qualified expenses tax-free far into the future. Owners can still contribute to the statutory maximum each year, regardless of their account balance or earnings in any year.

Flexibility

Although FSA stands for Flexible Spending Account, Health FSAs are somewhat rigid. Participants project their qualified expenses prior to the plan year and make a binding election. They can alter that election - up or down, start or stop - only with a qualifying life event such as birth, adoption, marriage, divorce, or death. They can't increase their payroll deductions if they incur unexpected expenses mid-year or discover mid-year that they're not a candidate for vision-correction surgery. And they must claim all reimbursements during the plan year or within the claims runout period (usually 90 to 120 days after the end of the plan year).

In contrast, Health Savings Account deserve the label flexible. Owners don't make a binding contribution commitment. They can adjust their level of deposits prospectively based on their financial and medical situations as they evolve. They can pay for qualified expenses with personal (not tax-advantaged) funds, save their receipts, and reimburse those expenses tax-free years or decades later.

When a Health FSA May Be the Right Option

Here are some situations in which a Health FSA may be the better account:

• It's the only account your company offers. Case closed. You don't have access to an HSA-qualified plan, so you can't open a Health Savings Account. You still enjoy the same tax benefits, albeit without the same level of flexibility.
• You want traditional rich medical coverage. Some people - particularly high utilizers of medical care, like those with chronic conditions that require regular care - are willing to pay more in premiums for a medical plan that reduces their out-of-pocket costs when they access services. These benefit designs don't meet the requirements for an HSA-qualified plan - the required coverage to open and fund a Health Savings Account. For these workers, a Health FSA is optimal, particularly if their expenses exceed their election limit (no regret over electing too little and no fear of unused balances to forfeit).
• You have disqualifying coverage. If you're enrolled in Medicare, Medicaid, or TRICARE (medical coverage for active and certain retired military personnel), you can't fund a Health Savings Account. A Health FSA gives you the tax benefits of a Health Savings Account, albeit without the degree of flexibility or unlimited time span.
• You need your funds up front. Health FSA participants can spend their entire election at the beginning of the plan year, then repay their employer through their ongoing payroll deductions. If you've scheduled major dental work or vision-correction surgery, or you face high medical cost-sharing (say, an inpatient stay) early in the year, this cash-flow feature may be attractive. Health Savings Account owners don't make a binding election commitment, so they have nothing against which to take a cash advance. But check with your Health Savings Account administrator, as many have created a feature that allows owners to, in effect, borrow against future contributions.

Health FSAs offer the same tax benefits as a Health Savings Account, but within a more rigid structure that reflects its status in the tax code as an employee benefit with a specific benefit year.

When a Health Savings Account May Be the Right Option

In many other situations, a Health Savings Account is the better option. Among them:

• It's the only account your company offers. No explanation necessary.
• You're not a traditional employee. Health Savings Account owners can be non-traditional workers - gig workers, consultants, free-lancers, business owners - and participate fully because it's not an employer-sponsored program. Even unemployed people with no earned income can open and fund an account. For most of the 14 million or so Americans who purchase coverage in the nongroup market, a Health Savings Account is their only option to reimburse qualified expenses with tax-free funds.
• You want to reduce taxes further. Health FSA tax savings are limited to annual election ceiling ($3,050 in 2023, although an employer can set a lower figure) and your projected qualified expenses (since you can't carry over unlimited balances). Health Savings Accounts have higher annual contribution limits (particularly for owners enrolled in family coverage) and permit unlimited carryover of unused funds. A Health FSA participant can reduce her taxable income by the lower of her employer's election limit or her projected qualified expenses, whereas the same employee, if under age 55 and enrolled on a family plan, can contribute $7,750 to a Health Savings Account in 2023. At a 22% marginal tax rate, the additional Health Savings Account federal income and payroll tax savings are nearly $1,400 ($4,700 additional reduction in taxable income at a tax rate of 7.65% for payroll taxes and 22% for income taxes).
• You want to save for retirement medical expenses. Fidelity annually calculates how much a typical couple retiring at age 65 will spend on health-related coverage (Medicare) and costs (deductibles, coinsurance, copays, services not covered by Medicare) during their remaining lifespans. In 2022, the figure was $315,000. Savvy retirement planners understand that Health Savings Accounts are the most tax-efficient way to save for those expenses, because neither contributions nor withdrawals for qualified expenses are included in taxable income. And you can invest balances to increase this nest egg over time. In contrast, traditional retirement plans are taxed either at the front end (contributions) or back end (distributions).
• You don't want to risk forfeiting balances. Health Savings Account owners don't need to project their annual qualified expenses carefully because they never lose funds in their account. They can adjust their contributions as their needs evolve during the year. This is an important advantage over Health FSAs, whose balances are subject to forfeiture (although, as noted above, employers can adopt one of two options to allow more time to spend some remaining balance).

In short, Health Savings Accounts offer superior financial advantages to those who meet eligibility requirements, value flexibility, and take a long-term view of their finances.

Either/Or?

The two accounts are not necessarily mutually exclusive. Under Health Savings Account rules, anyone covered by a general Health FSA (which reimburses the first dollar of qualified medical, dental, vision, and over-the-counter expenses) can't open or fund a Health Savings Account. Covered by in this context means that the individual, a spouse, or a parent is enrolled in an employer's Health FSA program.

But there are limited Health FSA designs that aren't disqualifying. The most popular is a Limited-Purpose Health FSA, which reimburses only dental and vision expenses (including over-the-counter items associated with this care). An individual can fund a Health Savings Account and be covered by this limited Health FSA design. The benefits of doing so include further reductions in taxable income and purchases of dental and vision products with pre-tax dollars without reducing Health Savings Account balances that can be used to reimburse future qualified expenses.

The Bottom Line

Health FSAs and Health Savings Accounts offer nearly identical tax benefits when viewed on an annual basis. Health Savings Accounts offer more flexibility, but at the expenses of a more rigid medical-plan design that may increase out-of-pocket financial responsibility for care. Employees who have a choice of one or the other plan must review their options and choose one or the other. Those who don't have the option of both plans face a choice: to participate or not participate. And most will benefit from reimbursing their qualified expenses tax-free.

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