Does an HSA Earn Interest and How Does It Work?
Discover how HSAs earn interest, their tax benefits, and the distinction between interest and investment gains.
Health Savings Accounts (HSAs) are financial tools designed to help individuals save for medical expenses. They offer tax advantages and the potential to earn interest on deposited funds. With healthcare costs rising, understanding HSAs can provide financial relief.
How Interest Accumulates
Interest accumulation in HSAs enhances their value over time. Unlike traditional savings accounts, HSAs often feature tiered interest rates, meaning the rate increases as the balance grows. For example, an account with less than $2,500 may earn a lower rate, while balances above $10,000 receive higher rates. This structure promotes long-term savings for future medical expenses.
Interest in an HSA is typically compounded monthly. Compounding adds the earned interest to the principal balance, so the next month’s interest is calculated on the larger amount. Over time, consistent contributions combined with compounding can lead to significant growth, creating a financial cushion for healthcare costs.
Tax Treatment
HSAs offer unique tax benefits. Contributions are tax-deductible, reducing taxable income in the year they are made. In 2024, contribution limits are $3,950 for individuals and $7,900 for families, with an additional $1,000 catch-up contribution for those aged 55 and older. Contributions can be made by account holders, employers, or third parties, providing funding flexibility.
Funds in an HSA grow tax-free, including both interest and investment gains, as long as they are used for qualified medical expenses outlined by IRS Publication 502. Withdrawals for these expenses are also tax-free. However, non-qualified withdrawals are subject to income tax and a 20% penalty, unless the account holder is over 65, disabled, or deceased. This penalty encourages the use of funds for healthcare purposes.
Differences Between Interest and Investment Gains
Interest and investment gains in HSAs serve different purposes. Interest provides a consistent, predictable return on the account balance, similar to a traditional savings account. Tiered interest rates reward higher balances, offering steady growth for those seeking stability without market risk.
Investment gains, on the other hand, come from allocating funds into options like mutual funds, stocks, or bonds. These investments have the potential for higher returns but carry market risks. For example, a diversified equity portfolio may yield significant gains during a bull market, potentially surpassing fixed interest growth.
The choice between interest and investment gains depends on individual risk tolerance and financial goals. Those with a higher risk appetite may prefer investments for their growth potential, while individuals nearing retirement or with low risk tolerance might prioritize the stability of interest earnings.