We love HSAs. They are better than 401(k)s and Roth IRAs because you get a tax break on the way in AND you can pull the money out tax-free for medical expenses at any age. While they are a terrific way to grow your money, they also come with some really complicated rules. In 2017, I wrote The Top 7 Things You May Not Know About Health Savings Accounts. That article talks about eligibility for a Health Savings Account (HSA) and qualifying distributions. Today’s blog delves deeper into some of the quirkier rules and changes since the first blog.
1. What is so special about an HSA?
An HSA is the only triple tax-free account:
1. Contributions are one of the easiest and smartest ways to lower your current taxes. When you save on a pre-tax basis into your 401(k) plan, you save on State and Federal taxes. If you contribute to your HSA through payroll deductions, you can also avoid paying FICA taxes (7.65%, as long as your company has a cafeteria plan)!
2 Your interest, dividends, and capital gains grow tax-free inside the HSA
3. Qualified distributions for medical expenses allow tax free access to your money at any age.
While it is nice to put $1,000 into an HSA, take the tax deduction, and then pull it right out for the instant gratification, HSAs work best when you invest the cash and allow your HSA to compound over decades.
2. When do qualifying expenses have to be reimbursed from an HSA?
You don’t have to withdraw money in the year you incur the medical expense. If you save your receipts and can prove the expenses were not deducted on your tax return or otherwise reimbursed, you could let your contributions compound for decades and then pull $100,000 or more out in one year from your HSA to pay for an around the world trip, kitchen remodel, or whatever you want. We pay cash for our out-of-pocket healthcare expenses and save the receipts and tax returns to give us the ability to make a big tax-free withdrawal. You never know when you might need some tax-free money.
3. How does Medicare affect HSAs?
Be careful with HSAs and Medicare. If you are still working at a job with good health insurance and have an HSA, our advice is almost always to delay signing up for the free, Medicare Part A Hospital insurance. Being entitled to Medicare will disallow you from making further contributions to your HSA. Enrollment is the process of signing up for Medicare, which you can typically do starting 3 months before your 65th birthday. Entitlement, however, means that you are actually covered by Medicare and can have claims paid. For most people this commences on the first day of the month you turn 65. Having a second insurance plan, not enrolling, is the trigger that disallows your ability to keep contributing to your HSA. If you sign up for Medicare 3 months before your 65th birthday, you can still contribute to your HSA until you are actually entitled to Medicare on the first day of the month you turn 65.
There is one other pitfall. Let’s say that Bonnie is 68 and has not signed up for Medicare and has been working in a job where she has an HSA eligible High Deductible Health Care Plan (HDHC). She wants to retire in November of 2023 and applies for Medicare in December. Medicare has a retroactive six month rule that provides coverage for the previous six months as long as you are 65.5 or older when you apply for Medicare coverage. This tricky rule will disqualify Bonnie from making contributions after May and she can only do 5/12s of her maximum HSA contribution for 2023.
4. Can I pay medical insurance premiums from my HSA?
No, unless the premiums are for any of the following:
- Long-term care insurance up to the IRS deductible limit*
- Health care continuation coverage (such as coverage under COBRA).
- Health care coverage while receiving unemployment compensation under federal or state law.
- Medicare and other deductible health care coverage (e.g. retiree medical coverage) if you are 65 or older (other than premiums for a Medicare supplemental policy, such as Medigap).**
*At age 65 you may pay $5,000 per year for your long-term care premium, but you can only deduct $4,510 that year based on the IRS deductible limit found here. The limits for 2022 are at age 40 or younger $450; 41 to 50, $850; 51 to 60, $1,690; 61 to 70, $4,510; and 71-plus, $5,640
**If the HSA is owned by a spouse who is under 65, they cannot make tax-free distributions for an older spouse’s Medicare premiums.
5. Can I contribute to an HSA if my spouse has a Flexible Spending Account (FSA)?
No. If your spouse is currently enrolled in a general-purpose FSA plan, then you are not considered eligible to contribute to an HSA. The FSA technically counts as ‘other insurance coverage’ and disqualifies your ability to contribute to an HSA even if you are not a dependent on your spouse’s health insurance plan.
Exceptions to this rule include limited purpose FSAs, which are limited to covering certain expenses such as dental, vision, and preventative expenses, and post-deductible FSAs that only reimburse expenses once the deductible is met. These types of plans are rare and need to be specifically designated as a limited purpose or post-deductible FSA.
6. How much can I contribute if I only had HSA eligible coverage for part of the year?
There are two ways to calculate this. The first method is to take the annual limit and multiply by the months you were covered on the first day of that month and divide by 12. Sam is a single man aged 53 who started a job on June 15th of 2022 and he wants to max out his HSA for tax year 2022. Sam’s employer contributed $500 to his HSA and the single contribution limit for 2022 was $3,650. Since Sam started in mid-June, he is only able to make contributions for July through December (6 months). The formula for Sam is $3,650- $500 (employer contribution) x 6/12= $1,575.
There is a special rule that allows Sam to contribute for the full year as long as he was covered by his HSA eligible health care plan on December 1st and he thinks he will be covered through December 31st of the following year. This can be huge for some people because it can help them lower their prior year taxable income and help them qualify for Roth IRAs, tax credits, and health care premium tax-credits from the exchange. If Sam is not covered for the entire following year, he will have to remove the six months of extra contribution he made in the new year and have to pay a 10% penalty and taxes on it.
7. Are over the counter (OTC) medications considered qualifying expenses?
Yes. Starting in 2020, many over the counter medications are qualifying expenses without requiring a doctor’s prescription. Before the Coronavirus Aid, Relief, and Economic Security (CARES) Act, you could not buy OTC medications with your HSA funds. The new law allows you to use your HSA to buy common OTC drugs like allergy, cough, and pain medicines tax-free!
8. What happens to my HSA when I die?
If the HSA is left to a surviving spouse, the surviving spouse is treated as the owner of the HSA and the account can continue in their name. As such, distributions by the surviving spouse are only taxable in the event of non-qualifying distributions.
If the HSA is left to a non-spouse beneficiary, the account ceases to be an HSA and the fair market value of the assets in the HSA on the date of death is included in the beneficiary’s income in that tax year.
If the HSA is left to the owner’s estate or there was no beneficiary listed, the date-of-death balance of the HSA is reported on the owner’s final income tax return.
If the deceased owner incurred qualifying medical expenses (and maintained documentation and receipts for them) any time prior to death that were not reimbursed by the HSA, the non-spousal beneficiary (other than the estate) can reimburse themselves for these expenses within one year after date of death and not have them included in their income.
Because of the bad and complicated death distribution rules, we recommend keeping years of receipts and tax returns and liquidating the entire HSA before you die to avoid this tax “penalty” on your heirs.
9. Can my spouse do a catch-up if he is on my family health care plan?
You betcha! Susan and Bob are both 56 years old and have 4 dependent children.. They are all covered by Susan’s High Deductible Health Care Plan at her job. The family maximum for 2023 is $7,750 for a family plan and since Susan is over 55, she can contribute $1,000 more as a catch up contribution. What most people in this situation miss out on is that Bob can go to an HSA custodian and open his own plan and contribute his $1,000 catch-up too!
10. My adult child is no longer my tax dependent, but is on my High Deductible Health Plan (HDHP). Can they contribute to their own HSA?
Yes! This is a crazy rule. If a husband and wife each have their own HDHP at work, they are limited to saving the 2023 maximum contribution of $7,750 (plus 55 and over catch-up for each spouse, if applicable) between the two of them. Let’s take a 24 year-old college student who is no longer a tax dependent because of their age and income level. This child can contribute up to $7,750 into their own HSA even though their parents have saved the maximum into their own. This rare situation is an excellent opportunity for parents who want to make gifts to their adult children. You potentially can get a lot of money growing tax-free for your child before they turn 26 and can no longer be on your health insurance plan.