In 2003, President Bush signed into law the Medicare Prescription Drug, Improvement and Modernization Act, allowing taxpayers to deposit tax-exempt money into Health Savings Accounts (HSAs), which they can use for qualified medical and health expenses during the year.

Lowering Your Tax Liability

An HSA gives you a tax break on medical expenses. For example, if you are in a 25% federal income tax bracket and use $2,000 of HSA funds for qualified medical expenses in one year, you deduct $500 from federal taxes owed.

Eligibility

According to the U.S. Department of Treasury, anyone 18 years or older who is covered by a high-deductible health plan (HDHP), is not covered by Medicare, and has no "first-dollar coverage" can set up an HSA. Such funds can be used toward health-care expenses of the individual as well as his or her eligible dependents.

Contribution Limits

According to the Internal Revenue Service, for 2010 an individual with an HDHP can contribute up to $3,050 to an HSA, and families with an HDHP have a cap of $6,150.

Additional Advantages

Unlike with a Flexible Spending Arrangement, the money you put into an HSA grows tax-free and carries over from year to year until you use it.

When Not to Use HSA Funds

HSA funds that are withdrawn for unqualified medical expenses (e.g., cosmetic surgery, nonprescription drugs) will be subject to federal income tax and (with some exceptions) to an additional 10% tax.

Source:

The U.S. Department of Treasury: About HSAs

The U.S. Department of Treasury: Health Savings Accounts, Notice 2008-52

Internal Revenue Service Publication 969: Health Savings Accounts and Other Tax-Favored Health Plans

More Information:

Internal Revenue Service Publication 502: Medical and Dental Expenses