HSAs work in conjunction with an HDHP. All the money you (or your employer) deposit into your HSA up to the maximum annual contribution limit is 100% tax-deductible from federal income tax, FICA (Social Security and Medicare) tax, and in most states, state income tax. This makes HSA dollars tax-free.

You can use these tax-free dollars to pay for expenses not covered under your HDHP until you have met your deductible.

The insurance company pays covered medical expenses above your deductible, except for any coinsurance; you can pay coinsurance costs with tax-free money from your HSA. In addition, you can use your HSA tax-free dollars to pay for qualified medical expenses not covered by the HDHP, such as dental, vision and alternative medicines.

If the funds in your account are used for other, nonmedical expenses, your dollars are subject to ordinary tax, plus a 20% penalty if you are under age 65.

The 20% penalty does not apply if the distribution occurs after you reach age 65, become disabled or die; however ordinary income tax may still apply. Funds remaining in your account at year-end are yours to rollover and accumulate for your future healthcare expenses. You may choose not to spend your HSA dollars on small expenses, instead using after-tax dollars to pay for these expenses, and leaving your HSA dollars to grow for future needs.

Choosing the expenses on which to spend your HSA dollars and which to pay out-of-pocket with after-tax dollars is entirely up to you.

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