People with tax-favored health savings accounts, otherwise known as HSAs, can spend money from the account on "qualified medical expenses," according to the IRS. These qualified medical expenses include the "costs of diagnosis, cure, mitigation, treatment, or prevention of disease, and the costs for treatments affecting any part or function of the body."
Think of an HSAs as a retirement account like a 401k, but for medical expenses. People divert a portion of pre-tax income to pay for medical expenses. Money in the account, and any interest or earnings it accrues, aren't taxed and can carry over year to year. In exchange for the tax benefits, IRS regulations restrict how HSA funds can be spent.
Health care costs grew faster than inflation between 1999 and 2009, according to data from the National Conference of State Legislatures. This forced an increase in insurance premiums, which raised expenses for businesses that have traditionally paid part or all of insurance benefits for workers. Policy makers have been convinced that if patients spent more of their own money on medical expenses, they would shop around for services and thus limit cost increases. This led to the creation of the high-deductible insurance plan, which offer lowers premiums--about $11,000 per year compared to $13,000 for traditional insurance--but higher out-of-pocket costs. To qualify for an HSA, a person must be enrolled in a high-deductible plan.
Policy makers hope that people will save enough in HSAs to cover the higher deductibles. To encourage saving, HSA funds cannot be used for items that are not considered qualified medical expenses. In 2011, IRS regulations will bar the purchase of over-the-counter medication. Insurance premiums are also prohibited, unless the patient paying for those benefits is over 65, receiving unemployment insurance or paying for benefits under COBRA. IRS regulations further prohibit withdrawing money from HSA for personal, non-medical expenses and the "sale, exchange, or leasing of property between you and the HSA, Lending of money between you and the HSA, furnishing goods, services, or facilities between you and the HSA, and transfer to or use by you, or for your benefit, of any assets of the HSA."
IRS regulations define qualified medical expenses pretty broadly. Acupuncture is covered. People who build wheelchair ramps on their homes to cope with a disability may also qualify, though the IRS is wary of improvements that also increase the value of a property, so be careful when installing elevators. The rules for which expenses qualify as medical expenses are contained in IRS Publication 502. The list includes mileage for certain treatment, treatment for alcoholism and transplants.
HSA funds are subject to penalties when used for expenses that do not qualify. Non-qualifying expenses, in the jargon of the IRS, are known as distributions. According to the IRS, "You can receive tax-free distributions from your HSA to pay or be reimbursed for qualified medical expenses you incur after you establish the HSA. If you receive distributions for other reasons, the amount you withdraw will be subject to income tax and may be subject to an additional 10 percent tax." The penalty will increase to 20 percent in 2011.