Health Savings Accounts (HSA's)

2024-08-21Year after year, the cost of medical care continues to increase. One significant contribution to this increase is that a 3^rd party — the insurance company — pays for most of the medical cost for the insured. Because the insured pays only a small portion of the direct cost, there is little motivation to shop around for services, which allows healthcare providers to inflate their price above what would otherwise be competitive. Consequently, the tax law provides for significant tax savings for special health savings accounts that are coupled with a high deductible health plan. Contributions to these health savings accounts (HSAs), created by the Medicare Modernization Act of 2003, are deductible in the year of the contribution and can later be withdrawn tax-free to pay for unreimbursed qualified medical expenses. Furthermore, the contributions grow tax-free within the HSA. The HSA is available to individuals or families covered by a high deductible health plan (HDHP) and the HDHP premiums are also deductible. However, because the deductions may not offset payroll taxes unless the contributions are made through a Section 125 salary reduction cafeteria plan and because the value of a deduction depends on the taxpayer's tax bracket, health savings accounts are less beneficial to lower-income taxpayers. Because the HSA makes it easier for the taxpayer to afford high deductibles and to also save on insurance premiums, the tax objective of providing HSAs is met by motivating taxpayers to shop around for medical services, which will presumably motivate healthcare providers to provide competitive pricing.

Contributions via a Section 125 cafeteria plan by the employer or by the employee are also free of FICA taxes (Social Security and Medicare taxes, a.k.a. payroll taxes). Contributions outside of a Section 125 plan are still deductible from ordinary income tax, but they are subject to FICA taxes. Section 125 contributions are reported in Box 12 of Form W-2, Wage and Tax Statement with code W. 

Unlike IRAs and other tax-advantaged retirement accounts, an HSA also has no income limit for making contributions, so even millionaires can contribute to an HSA. An HSA can also be used to increase the amount saved for retirement, if you do not use the funds to pay for qualified health expenses. If you are at least 65, you can withdraw money from an HSA without penalty. However, like a distribution from a traditional IRA, the amount is subject to ordinary income tax.

Another major advantage is that there is no adjusted gross income (AGI) floor to deduct HSA contributions as there is for medical and dental expenses. (In fact, you could contribute to an HSA, then shortly thereafter, withdraw the contribution to pay qualified medical expenses. However, if your deduction is large enough, and if you could afford it, it may be wiser to leave the money in the HSA to grow tax-free while deducting your out-of-pocket costs as an itemized deduction.) Furthermore, the contributions will also lower the alternative minimum tax, which also has a 7.5% AGI floor for deducting medical and dental expenses.

Additional advantages include:

• HDHPs satisfy the individual mandate under the Affordable Care Act.
  • However, HSAs cannot be used with most plans purchased from government exchanges — not even the bronze plans. Whether the plans qualify for an HSA is listed in the detailed description of each plan at HealthCare.gov.
• HSA contributions can be deducted from gross income without itemizing.
• Unused savings can be carried forward to future years. Those who qualify for Medicare cannot contribute any more money to an HSA, but they can withdraw money without incurring a 20% tax penalty for withdrawals not used to pay for qualified medical expenses, but ordinary income taxes still apply for those distributions.
• If the HSA account owner dies before using up all the money, then the remaining amount can be transferred to a surviving spouse, who can then use it for any purpose.
• Most HSAs offer debit cards for spending, allowing accurate records to be kept.
• If medical expenses exceed what is in the account, then the taxpayer can save the receipts, then reimburse themselves from the account later, after more money has been deposited.
• More than 1 HSA is permitted.
• HSAs can fund Medicare premiums.
• You can pay for eligible expenses by cash, then take tax-free reimbursements from your HSA later, even years afterward, if you have the expense receipts.
• Adult children can remain on their parents' plan until age 26, so if the parents' healthcare plan qualifies for an HSA, then the child can set up their own HSA based on that plan, so they can receive the benefit of HSA contributions without paying for the health plan.
  • Furthermore, the limits on these contributions are the family amount, not the individual amount, even if they are single.

• HSAs can only be inherited by a spouse.
  • If the spouse does not inherit the HSA, then the amount becomes taxable.
  • However, the funds can be used by the executor of the estate within 1 year of death to pay medical bills or claim prior expenses that were paid out-of-pocket, if there is proof for the claim.

Eligibility

A taxpayer cannot use an HSA if he has any health coverage that does not meet the high deductible requirement of an HDHP unless it is permitted coverage, including:

• coverage that provides preventive care benefits, even if no deductible is charged or is less than the minimum annual deductible,
  • preventive care generally includes immunization shots, screening tests, and even HIV and sexually transmitted diseases, diet and obesity, and alcohol counseling services (see What are my preventive care benefits | HealthCare.gov for more information);
• coverage for vision, dental, disability or long-term care, and accidents;
• per diem insurance while hospitalized;
• insurance for specific diseases, such as cancer, diabetes or heart disease; and
• insurance relating to workers' compensation or tort liability, such as liabilities arising from the ownership of property.

An HSA can be opened in any month when the taxpayer:

• was covered by a HDHP on the first day of the month;
• was not covered by any plan that is not a HDHP or that is not permitted coverage;
• was not enrolled in Medicare; and
• was not claimed as a dependent.

To be eligible for the tax year, the taxpayer must be covered by an HDHP by December 1. Recapture rules may apply if the taxpayer ceases to be eligible for an HSA, in which case, the amount contributed to the HSA minus monthly contribution limits that would otherwise apply must be added to gross income and would be subject to a 10% penalty.

HSA eligibility is determined monthly. On the beginning of each month, the individual must be covered by a HDHP and not covered by any unqualified health plan.

Dependents can be covered by the HDHP even if the taxpayer's gross income is more than the phaseout amount for claiming the dependency exemption. Divorced or separated parents can claim a child as a dependent for HSA purposes, without regard to who claims the child as a dependent.

HSA Accounts

An HSA is set up with an insurance company, bank, or other financial institution that has been approved by the IRS for HSAs. The institution reports contributions by the taxpayer on Form 5498-SA, HSA, Archer MSA, or Medicare Advantage MSA Information. HSA's supplant Archer MSAs, which provided similar tax benefits.

The HSA must be set up by year-end, but it can be funded until the earlier of when your tax return is filed or the April tax deadline.

The HSA is like a traditional IRA account, in that contributions are deductible and the money can grow tax-free. Note, however, that some states do tax earnings on HSA investments.

HSA distributions are also not taxed if they are used to pay for qualified medical expenses. Distributions from HSA accounts can be used to pay for medical expenses not covered by the deductible and for out-of-pocket costs and can also be used to pay for medical expenses that qualify as an itemized deduction. HSA distributions can also cover expensive medical devices that are not ordinarily covered by insurance, such as hearing aids.

HSA Contributions, Annual Limits, and Distributions

The HDHP is defined by annual deductible limits and maximum annual limits on out-of-pocket costs (deductible + co-payments), both which are adjusted for inflation:

There is also a catch-up contribution limit of $1,000 for those people aged 55 or older by the end of the tax year, which can be added to the maximum contribution limits listed in the above table.

If you do not have HDHP coverage for the entire 12 months, then the allowable additional contribution amount = $1,000 × number of months with HDHP coverage / 12.

Taxpayers age 65+ cannot contribute to an HSA, since they are eligible for Medicare.

The contribution limits do not depend on the time of year when the HSA was first opened, even if it was at year-end. The last-month rule allows contributions to be made up until the due date of the filing of the return, not including extensions if the you were covered by an HDHP by December 1 of the tax year.

However, if you contribute the full amount for the year in which HDHP coverage began on December 1, but then fail to maintain HDHP coverage for the 12 months after becoming qualified for the HSA, then an amount proportional to the number of months without HDHP coverage must be added as income and will be subject to a 10% additional tax.

Although more than one HSA is allowable, the maximum annual contribution limits applies to the aggregate contributions. Spouses who are both eligible for HSAs can decide how to allocate the HSA contributions. When an individual becomes enrolled in Medicare Part A or B, usually at age 65, no additional contributions can be made.

The maximum contribution is reduced by any qualified HSA funding distributions, contributions made to the taxpayer's Archer MSA, or any employer contributions to the employees' HSA.

The employer can contribute to an HSA on behalf of its employees, and the contributions are excludable from employees' income, but the total contributed by both employer and employee cannot exceed the applicable limit.

Any contributions above the HSA limit are not only not deductible but are also subject to a 6% excise tax. Any excess amount of contributions by an employer on behalf of an employee is included in the employee's income and subject to the excise tax. The excise tax can be avoided if the excess and any income earned by the excess contribution are withdrawn by the due filing date including extensions. However, the excise tax can also be avoided if withdrawals are made by October 15. Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts provides further details.

Distributions from HSA's, reported on Form 1099-SA, Distributions From an HSA, Archer MSA, or Medicare Advantage MSA, are tax-free if they are used to pay or reimburse qualified medical expenses of the taxpayer, spouse, or dependents. Otherwise, the distributions are taxable and subject to an additional 20% penalty unless the taxpayer is at least 65, disabled, or dead. If the HSA plan allows it, a taxpayer can repay an expense that was not a qualified medical expense to avoid the 20% penalty, if done by April 15 of the next year from when the mistake was discovered or should have been discovered.

Some qualified expenses include insurance co-pays and deductibles, first-aid supplies, heating pads, sunscreen, and hearing aids. If the taxpayer has Medicare, then all Medicare expenses, such as deductibles, premiums, co-pays, and coinsurance, are also qualified expenses.

You may receive a distribution for a qualified expense in the previous year if the expense was not claimed as an itemized deduction or was otherwise reimbursed. You may want to do this if there was insufficient funds in the HSA account in the previous year to pay the expense.

You can make a tax-free trustee to trustee transfer of funds from a traditional or Roth IRA to an HSA, referred to as a qualified HSA funding distribution. Only one such distribution is permitted per lifetime, subject to the annual limits for that tax year and for the taxpayer. However, an additional distribution may be made in the same tax year if you change from self-coverage to family coverage. The distribution is neither tax-deductible nor taxable.

However, the HSA funding distribution is qualified only if you maintain eligible health insurance for at least 1 year after the month of the distribution; otherwise, the distribution must be added to taxable income and will also be subject to a 10% tax penalty. So if the distribution occurs in mid-January, then you must maintain qualified health insurance until the end of February of the next year. The tax penalty will not apply if you die or become disabled, but there is no age exception to the penalty.

The IRS can levy HSA's to recover unpaid taxes, and if you are under 65, a 20% penalty applies to this involuntary withdrawal.

Qualified Medical Expenses

Qualified medical expenses include:

• all expenses that qualify as itemized medical and dental deductions;
• medications for which the taxpayer has a doctor's prescription, whether the medication requires a prescription or not;
• premiums for long-term care insurance, COBRA health care or other continuation coverage; and
• health coverage for taxpayers receiving unemployment.

For taxpayers over 65, HSA distributions can be paid for the premiums of Medicare Part A, B, or D, Medicare HMO, or for the employee's share of premiums for employer-sponsored health insurance or for retiree's health insurance. HSA distributions that are used to pay for long-term care premiums are tax-free up to the age-based deductible limit for the premiums.

However, HSA distributions cannot be used to pay HDHP premiums. Payments for over-the-counter medicines which do not require prescription and for which the taxpayer does not have a doctor's prescription are taxable and subject to the 20% penalty.

Distributions to HSA's

A one-time distribution can be made by an employer from an employee's health flexible spending arrangement (FSA) or health reimbursement account (HRA) to the employee's HSA. An employee can also choose to transfer funds for one time only to his HSA from an IRA. The amount distributed from an IRA to an HSA reduces the total contribution that the individual may make that tax year and the transferred amount is not deductible.

Inherited HSA's

A surviving spouse can inherit the HSA of a deceased spouse and it can continue as an HSA for the surviving spouse. If the beneficiary is not the surviving spouse, then the HSA amount is includable in the beneficiary's income, which can be reduced by any HSA payments made by the beneficiary for the decedent's medical expenses within 1 year after death.

Form 8889

Form 8889, Health Savings Accounts is used to calculate and report HSA contributions, distributions and any penalties and must be attached to Form 1040. The HSA custodian reports any distributions to the IRS on Form 1099-SA, Distributions From an HSA, Archer MSA, or Medicare Advantage MSA. Form 8889 is divided into 3 parts.

1. Part I. HSA contributions are reported and the deductible amount is calculated.
2. Part II. Tax-free and taxable HSA distributions are reported and the 20% additional tax is calculated for taxable HSA distributions subject to it.
3. Part III. For a trustee-to-trustee distribution, such as from an IRA to an HSA, the taxpayer must maintain HDHP coverage for the year after the beginning of the month that the distribution was made. Otherwise the amount distributed becomes taxable and is also subject to a 10% additional tax, unless the taxpayer dies or becomes disabled.

Conclusion

Although health savings accounts are nice, it would be a lot nicer if the insurance premiums were tax-free not only from the marginal tax rate but also from employment taxes, as they are for employees as a fringe benefit when offered by a C corporation.