What Happens to the HSA Money When You Cancel Insurance?

HSAs, or health savings accounts, are tax-favored savings accounts available to people enrolled in high-deductible health insurance plans. They're similar to 401k retirement accounts in that money is added to them on a pretax basis. Money in an HSA is restricted to medical expenses. If you have an HSA and cancel insurance, you keep the money, but restrictions remain on how you can spend the money. Unqualified expenditures are taxed as income and subject to a 20 percent penalty as of 2011.

It's Your Money

• Like 401ks, HSAs offer sizable tax benefits. Money in an HSA can come from a variety of sources. It's usually diverted from an employee's paycheck to the account; like 401ks, this is done on a pretax basis. If you're self-employed, money is also contributed on a pretax basis. The contributions lower a wage earner's adjusted gross income, and therefore his overall tax liability.

Determining Qualified Expenses

• Under IRS rules, you can deduct medical expenses any time your annual medical bills exceed 7.5 percent of your adjusted gross income. IRS Publication 502 details which expenses qualify for the deduction. The IRS says that HSA account holders should also refer to this publication when determining which expenses are qualified expenses, though there's no spending threshold for the tax-free use of HSA funds. Qualified 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."

Qualified Expenses: The Details

• If you cancel your insurance because you got a new job with more comprehensive insurance, you may be wondering what you can spend HSA funds on without incurring the tax penalty. There's a long list of what qualifies and what doesn't in Publication 502. Acupuncture, for example, is a qualified expense. However, vitamin supplements and other herbal medicines don't qualify unless prescribed by a doctor. In general, expenses prescribed by a doctor qualify. You can also cover copays and other expenses not covered by your new plan --- ambulance rides, for example.

Continuing Medical Insurance

• If you cancel your insurance, there are narrow circumstances under which you may use your HSA funds to pay for new insurance premiums. In general, you can't use HSA funds to pay health insurance premiums. But if you have lost insurance because you lost your job, you can use HSA funds to pay for continuing insurance under COBRA. You may also use HSA funds for health insurance premiums if you're receiving unemployment compensation or using funds for Medicare

Account Features

• Money in an HSA account can accrue interest. Certain accounts can be invested in the stock market. All of the gains are tax-free. IRS regulations limit the amount of money that taxpayers can put in HSA accounts, a feature that prevents them from becoming tax shelters for wealthy individuals. Workers with individual coverage can divert up to $3,000 to an HSA as of 2010. Workers with family coverage can send $5,950 to their HSAs.