Are health insurance premiums taking too big of a bite out of your budget? Do you wish you had better control over how you spend your health-care dollars? If so, you may be interested in an alternative to traditional health insurance called a health savings account (HSA).

How Does a Health Savings Account work?
An HSA is a tax-advantaged account that's paired with a high-deductible health plan (HDHP). Let's look at how an HSA works with an HDHP to enable you to cover your current health-care costs and also save for your future needs.

Before opening an HSA, you must first enroll in an HDHP, either on your own or through your employer. An HDHP is "catastrophic" health coverage that pays benefits only after you've satisfied a high annual deductible. (Some preventative care, such as routine physicals, may be covered without being subject to the deductible.) For 2007, the annual deductible for an HSA-qualified HDHP must be at least $1,100 for individual coverage and $2,200 for family coverage. However, your deductible may be higher, depending on the plan.

Once you've satisfied your deductible, the HDHP will provide comprehensive coverage for your medical expenses (though you may continue to owe co-payments or coinsurance costs until you reach your plan's annual out-of-pocket limit). A qualifying HDHP must limit annual out-of-pocket expenses (including the deductible) to no more than $5,500 for individual coverage and $11,000 for family coverage (for 2007). Once this limit is reached, the HDHP will cover 100% of your costs, as outlined in your policy.

Because you're shouldering a greater portion of your health-care costs, you'll usually pay a much lower premium for an HDHP than for traditional health insurance, allowing you to contribute the premium dollars you're saving to your HSA. Your employer may also contribute to your HSA, or pay part of your HDHP premium. Then, when you need medical care, you can withdraw HSA funds to cover your expenses, or opt to pay your costs out-of-pocket if you want to save your account funds.

An HSA can be a powerful savings tool. Because there's no "use it or lose it" provision, funds roll over from year to year. And the account is yours, so you can keep it even if you change employers or lose your job. If your health expenses are relatively low, you may be able to build up a significant balance in your HSA over time. You can even let your money grow until retirement, when your health expenses are likely to be substantial. However, HSAs aren't foolproof. If you have relatively high health expenses (especially within the first year or two of opening your account, before you've built up a balance), you could deplete your HSA or even face a shortfall.

HSA as a Tool for Tax Reduction

HSAs offer several valuable tax benefits:

• You may be able to make pretax contributions via payroll deduction through your employer, reducing your current income tax.
• If you make contributions on your own using after-tax dollars, they're deductible from your federal income tax (and perhaps from your state income tax) whether you itemize or not. You can also deduct contributions made on your behalf by family members.
• Contributions to your HSA, and any interest or earnings, grow tax deferred.
• Contributions and any earnings you withdraw will be tax free if they're used to pay qualified medical expenses.

Consult a tax professional if you have questions about the tax advantages offered by an HSA.

Can Anyone Open an HSA?

Any individual with qualifying HDHP coverage can open an HSA. However, you won't be eligible to open an HSA if you're already covered by another health plan (although some specialized health plans are exempt from this provision). You're also out of luck if you're 65 and eligible for Medicare or if you can be claimed as a dependent on someone else's tax return.

How Much Can I Contribute to an HSA?

Each year, you can contribute up to $2,850 for individual coverage and $5,650 for family coverage (for 2007). This limit applies to all contributions, whether they're made by you, your employer, or your family members. You can make contributions up to April 15th of the following year (i.e., you can make 2007 contributions up to April 15, 2008). If you're 55 or older, you may also be eligible to make "catch-up contributions" to your HSA, but you can't contribute anything once you reach age 65.

Note: Starting in 2007, you'll be able to make a one-time tax-free rollover of funds to your HSA from a health flexible spending account (FSA), a health reimbursement arrangement (HRA), or a traditional IRA (certain limits apply).

Can I Invest My HSA funds?
HSAs typically offer several savings and investment options. These may include interest-earning savings, checking, and money market accounts, or investments such as stocks, bonds, and mutual funds that offer the potential to earn higher returns but carry more risk (including the risk of loss of principal). Make sure that you carefully consider the investment objectives, risks, charges, and expenses associated with each option before investing. A financial professional can help you decide which savings or investment options are appropriate.

How Else Can I Use My HSA Funds?
You can use your HSA funds for many types of health-care expenses, including prescription drugs, eyeglasses, deductibles, and co-payments. Although you can't use funds to pay regular health insurance premiums, you can withdraw money to pay for specialized types of insurance such as long-term care or disability insurance. IRS Publication 502 contains a list of allowable expenses.

There's no rule against using your HSA funds for expenses that aren't health-care related, but watch out--you'll pay a 10% penalty if you withdraw money and use it for nonqualified expenses, and you'll owe income taxes as well. Once you reach age 65, however, this penalty no longer applies, though you'll owe income taxes on any money you withdraw that isn't used for qualified medical expenses.