A health savings account (HSA) is a useful savings tool. It allows money to be set aside tax-free to pay for future medical expenses. An HSA can be opened with a qualified HSA trustee or anyone already approved to be a trustee of an individual retirement account (IRA)—such as a brokerage firm—or an Archer medical savings account (MSA). Distributions are tax-free regardless of how much capital appreciation, dividend income or interest income has been realized as long as the dollars are spent on qualified expenses. Plus, the accounts are portable, meaning that they stay with the person even if there is a change in employment.

Though these accounts have several advantages, there are several restrictions. Only individuals enrolled in plans with deductibles and expenses falling into a specified range and who have not enrolled in Medicare can contribute. Distributions must be spent on qualified medical expenses. Failure to adhere to the rules can result in taxes and additional penalties being levied.

HSA Qualification Rules

In order to contribute to a health savings account, a person must be covered by a high-deductible health plan (HDHP) and must not be enrolled in Medicare. The Internal Revenue Service (IRS) defines a high-deductible health plan as having a higher annual deductible than typical health plans and a maximum limit on the total annual deductible and out-of-pocket medical expenses an enrollee must pay for covered expenses.

As a general rule, the high-deductible health plan must be the only medical coverage a person (and his/her spouse in the case of family coverage) has. Exceptions include, but are not limited to, additional coverage for a specific illness or disease, hospitalization (must be for fixed daily reimbursement), accidents, disability, dental care, vision care and long-term care.

The minimum and maximum annual deductibles are updated annually and can be found at IRS.gov in IRS Publication 969: Health Savings Accounts and Other Tax-Favored Health Plans. For 2016, the minimum annual deductible for self-only coverage is $1,300; it is $2,600 for family coverage. The maximum limits for annual deductible and other out-of-pocket expenses are $6,550 and $13,100, respectively.

The family coverage limits apply when the high-deductible health plan covers an eligible individual and at least one other individual. If the deductible for the entire family or the deductible for an individual member of the family is less than the minimum annual deductible for family coverage, the plan will not qualify.

HSA Contribution Rules

Contributions to a health savings account can be made by an eligible individual, an employer, family members “or any other person.” Contributions not made by your employer are deductible regardless of whether you itemize deductions or not. Contributions made by an employer are excluded from an employee’s income for tax purposes.

Contributions are only permitted to be made in cash. The deadline for making contributions is generally April 15 (it will be April 17, 2017, for a 2016 contribution since April 15, 2017 falls on a Saturday). Total contributions—regardless of the source—are limited to $3,350 for individual and $6,750 for family coverage in 2016. Employer contributions reduce the amount an individual can contribute. The amounts are updated annually in IRS Publication 969. Eligible individuals age 55 or older at the end of their tax year can contribute an additional $1,000 per tax year.

The contribution limit falls to zero the first month a person enrolls in Medicare.

If qualified HDHP coverage was not maintained for the entire year, the contribution limit is dependent on one of two scenarios. The first is to prorate the contribution limit based on the number of months that HDHP coverage was maintained on the first day of the calendar month. If an individual has qualifying coverage from January 1 through June 15 of a calendar year and then changes to a plan that does not meet the high-deductible health plan requirements, the contribution limit would be $1,675. The math is $3,350 × (six months of coverage ÷ 12 months).

The second method is the last-month rule. A person is considered to be an eligible individual if enrolled in a high-deductible health plan on the first day of the last month of his or her tax year, which is typically December 1. If so, eligibility is considered to have existed for the entire calendar year and the full allowable amount can be contributed to the HSA provided a testing period for eligibility is not failed.

If the last-month rule is used, a person must remain “an eligible individual” for the full testing period. The testing period begins with the last month of the person’s tax year and ends 12 months later on the last day of the last month (for example, December 31 of the next calendar year). Note that the testing period is for a 12-month period and not a calendar year, even though the two will often overlap.

To understand how this works, assume a person enrolled in a high-deductible health plan on November 1, 2015. On December 31, 2015, he took advantage of the last-month rule and contributed $3,350 to his HSA. (The maximum contribution limits for individuals were unchanged between 2015 and 2016). In June 2016, he switched to a new plan that does not qualify as a high-deductible health plan under the IRS rules. This change caused him to fail the testing period. He must now treat the equivalent of 10 months of HSA contributions as ordinary income for the 2016 tax year since he is only considered to have had qualifying coverage for November and December of 2015. He must also pay an additional 10% penalty on the amount of the excess contribution.

Contributions, known as funding distributions, can be made from a traditional individual retirement account (IRA) or a Roth IRA, but not from an ongoing SEP-IRA or a SIMPLE IRA. The funding distribution is excluded from taxable income and is not deductible. A funding distribution has the advantage of allowing you to pay for qualified medical expenses without having to make a taxable withdrawal from your traditional IRA. A funding distribution reduces the amount you can contribute to an HSA, however. Only one funding distribution is allowed during a person’s lifetime, unless the person changes from self-only HDHP coverage to family HDHP coverage and makes the second funding distribution during a later month of the same year. The funding distribution must be made directly from the trustee of the IRA (e.g., the brokerage firm) to the trustee of the HSA (e.g., the brokerage firm where the account is set up).

Any excess contributions are subject to a 6% excise tax. The tax can be avoided if the amounts are withdrawn by the due date of the tax return for the year contributions were made (a tax extension pushes back the due date) and any income on the excess contributions are withdrawn and reported as “other income.”

HSA Distributions

As previously stated, health savings account distributions can be used to pay for qualified medical expenses incurred after you open the HSA. These are expenses that are generally eligible for the medical expense deduction (see IRS Publication 502 for a description of them). Non-prescription medicines cannot be paid for with HSA dollars, with the exception of insulin. Qualified expenses include medical costs incurred by the account holder, his or her spouse, and any dependents (certain exceptions apply on dependents, such as a limit of $4,000 of gross income earned by that person). You are not permitted to both use HSA dollars to pay for a medical expense and claim a tax deduction on the same expense.

Distributions from an HSA can be used to pay for long-term care insurance. Those premiums are subject to age-based limits and are adjusted annually. Details are included in the instructions Schedule A (1040); look under “Limit on long-term care premiums you can deduct.”

Distributions can also be used to pay for Medicare and other health coverage for those age 65 and older (but not Medicare supplemental policies), COBRA and related continuation coverage and health care coverage while receiving unemployment insurance. HSA dollars cannot otherwise be used for insurance premiums. Distributions not used for qualified medical expenses will be levied an additional 20% tax. This penalty is waived for those age 65 or older or disabled.

All expenses must occur after the HSA was established. There is no time limit when the HSA dollars must be spent, however. As such, the contributions made to a health savings account can be invested and are allowed to appreciate in value over a period of many years before distributions are taken. The distributions are completely tax-free if spent on qualified medical expenses regardless of how much the account balance has grown due to capital appreciation and income earned on the investments. These traits make health savings accounts a useful vehicle for accumulating retirement savings or to pay for significant expected future medical expenses.

Upon the death of the account holder, the account becomes his or her spouse’s HSA if the spouse is named as the account’s beneficiary. If a non-spouse beneficiary is named, the account ceases to be an HSA and the balance is treated as taxable income at its fair market value. The value of the account is included on the final estate tax return if the estate is the beneficiary.

Visit IRS.gov for full instructions on HSAs and updates on limits and maximums.