How Does Pretax Medical Affect My Tax Return?

When you contribute to a qualified health savings account, you have extra money to meet expenses not covered by high-deductible medical insurance. The money comes directly from your paycheck before it's taxed. If your weekly salary is $1,000, and your HSA contribution is $50, then your taxable income for the week is $950. The HSA contribution reduces income as well as payroll tax, which as of the date of publication took a 7.65 percent bite out of gross wages. The same basic rules apply to flexible spending arrangements, which use pretax dollars to pay medical expenses not covered by employer-provided health insurance.

On your tax return, contributions to an HSA are subtracted from your gross income, whether you're covered by an employer-provided plan or have set up a plan as self-employed individual. You use Form 8889 to report total contributions to and distributions from to a qualified plan. The maximum contribution for an individual was $3,100 for 2012, with an additional $1,000 allowed for those 55 or older. The allowed deduction from gross income goes on line 25 of Form 1040. You don't need to report FSA contributions to the IRS.

As of 2013, the maximum amount you may contribute to an FSA is $2,500 a year. It's important to consider the "use it or lose it" rule with flexible spending arrangements. If you don't use the money saved within the calendar year for your medical expenses, then you simply lose it -- the balance in the account goes to zero, with no refund. The IRS allows employers to offer a grace period of up to two and a half months in the following year if you haven't yet spent the FSA money. In any case, if the amount forfeited is greater than the tax savings on the pretax income, you're losing money on the deal. With an HSA, you can roll the contributions to the following year.

Another tax consideration will arise if you use the money for non-health expenses. If you withdraw money from an HSA and don't spend it on qualified medical expenses, the IRS will penalize you 20 percent of the amount withdrawn, on which you must also pay ordinary income tax. In addition, you can't pay for medical expenses out of an HSA and then claim them as itemized deductions on Schedule A.