HOW TO NAVIGATE MEDICARE AND HSAs TO AVOID TAXES AND PENALTIES
Recently I have had several client inquiries from pre-retirees regarding the need to cash out their Health Savings Accounts (HSAs) before they sign up for Medicare. After dispelling this financial planning urban myth, I saw the need to write about this topic. The confusion comes from the nuances of these two programs, both have plenty. I’ll explain the What and the Why here and teach you how to optimize the benefits of both programs by minimizing taxes and penalties. Let me start with the basics of each, and then help you avoid and even fix the Medicare and HSA tax collisions.
HSAs are terrific tax efficient savings accounts because they are triple tax free. Generally, the contributions to these accounts are tax deductible, earnings grow without generating tax liabilities, and withdrawals are tax free if they are used to pay for qualified medical expenses. To be eligible to contribute to an HSA, the taxpayer must be enrolled in what is known as a high-deductible health plan (HDHP). For 2022, the IRS defines a HDHP as any plan with a deductible of at least $1,400 for an individual, or $2,800 for a family. At the other end, a HDHP’s total yearly out-of-pocket expenses (deductibles, copayments, and coinsurance) can’t be more than $7,050 for an individual, or $14,100 for a family. The gross 2022 HSA contribution limits are $3,650 for a taxpayer filing single, and $7,300 for Married Filing Jointly taxpayers. Both groups have an additional $1,000 annual catch-up contribution limit for taxpayers over the age of 55. Your annual HSA contribution limit is always prorated based on the number of months you are solely covered by a HDHP to arrive at your net contribution limit. More on this nuance will follow.
Medicare is the federal health insurance program supported by workers and their employers with a special payroll tax, along with user monthly premiums. This program covers Americans aged 65 and older (it also includes others living with certain disabilities for chronic conditions). There are several components of Medicare, here is a summary:
Part A – provides inpatient hospital coverage
Part B – provides outpatient medical coverage
Part C – an alternate way to receive your Medicare benefits, it works like an HMO or PPO by combining Parts A, B & D
Part D – provides prescription drug coverage
When Medicare coverage starts
The Initial Enrollment Period is targeted to when you reach age 65. This enrollment period is 7-months. It starts 3-months before you reach age 65 and ends 3-months after the month you reach age 65. Coverage always starts on the first of the month.
After your Initial Enrollment Period ends, you can only sign up for Part B (and Premium-Part A) during one of the other enrollment periods:
General Enrollment Period – this is between January 1 and March 31 each year.
Special Enrollment Period – there are certain situations when you can sign up for Part B, and premium Part A without paying a late enrollment penalty. This enrollment window has very specific conditions related to you no longer being eligible for your (or your spouse’s) group health plan coverage, and it is only available for a limited time. If you miss this window, then you will have to wait for the next General Enrollment Period and pay late enrollment fees. See Medicare.gov for more information.
Part B (and Premium-Part A): Coverage starts based on the month you sign up as follows:
While the Medicare premiums can be expensive, the deductibles of this program do not fit the IRS’s definition of an HDHP. The deductibles component of Medicare is the important distinction that disqualifies its customers’ ability to establish and/or contribute to an HSA. In addition to prepaying with after-tax dollars for Medicare throughout your career, the premiums you pay for this coverage depends on your Modified Adjusted Gross Income (MAGI) amount from your tax return two (2) years prior. Click HERE to see the Medicare premium rates for 2022. This 2-year lag is to give the IRS time to send the needed tax information to the Department of Health and Human Services (HHS) who oversees Medicare.
To summarize, you cannot establish or “contribute” to an existing HSA while receiving Medicare coverage. Whereas, if you have an HSA, you can continue to use the HSA funds for medical expenses while paying for Medicare insurance. Additionally, you can use your HSA funds to pay your Medicare Parts A, B, C & D premiums, although not for the Medicare Supplemental Insurance premiums. Beginning at age 65 you can also use HSA funds to pay premiums for employer sponsored health care insurance. Additionally, if you are at least age 65 you can take distributions from your HSA for nonmedical expenses without paying the 20% withdrawal penalty, although these distributions are taxed at your Federal ordinary income tax rate. In the latter case, you loose one of the three tax free benefits of funding your HSA, so avoid this if possible.
Where HSA Tax Law and Medicare Collide
Navigating Medicare rules and HSA tax law can get tricky because of the retroactive way Medicare commences if you sign up for Medicare after the age of 65, along with the HSA eligibility regulations. You may be wondering why does Medicare have a 6-month retroactive coverage period? First, this only applies to people over the age of 65 who did not enroll in Medicare when they reached age 65. The reason for this is back in 1983 the Department of Health and Human Services started backdating Medicare coverage to ensure that people coming off employer health coverage would not inadvertently be uninsured during the transition to Medicare. This was thoughtful. The tax regulations for the roll-out HSAs were not established until 2003.
Enrolling in Medicare after the age of 65 is becoming more common now that people are remaining in the workforce longer. Many in this group find their employer’s health plan provides better coverage and/or is less expensive for them than Medicare. Some employer provided plans do not cover employees who have reached the age of 65, so check your company’s healthcare benefits program. In this post age 65 enrollment situation there is an up to six-month retroactive medical and health coverage that begins no earlier than the first day of your birth month when you reach age 65. Because of the Medicare retroactive coverage, it may collide with the Internal Revenue Code (IRC) HSA eligibility regulations which may cause a 6% excise tax on excess HSA contributions made beyond your annual contribution limit.
To avoid the 6% excise tax on what the IRS defines as excess HSA contributions, you and/or your employer need to stop contributing to an HSA prior to breaching your annual contribution limit. More specifically, your HSA contribution limit is prorated by months of eligibility. For example, based on your health care insurance plan(s) coverage, say you are eligible for to contribute to the HSA for 7-months, then your specific HSA contribution limit is 7/12ths of the published annual limit. For 2022 the full 12-month of eligibility contribution limits are $3,650 for a taxpayer filing single, or $7,300 for Married Filing Joint taxpayers (plus the $1,000 catch-up contribution for either filing status if at least age 55). In this example your net eligible contributions would be $2,129 if single, and $4,258 if for a family (plus the prorated catch-up contribution if eligible by age).
Remember, the retroactive component of Medicare does not kick in if you sign up for Part B before age 65. You still must prorate your HSA contribution limit based on the number of months you solely participated in an HDHP, although you don’t have to be concerned with any retroactive Medicare coverage. If you are 65 and 4 months of age when you begin receiving Medicare coverage, then the retroactive period is only 4-months, not the entire 6-months. Regardless of whether you needed or used the retroactive feature of Medicare, from the tax law perspective, the retroactive month Medicare covers you is what stops the counting of months for HSA contribution eligibility in determining your net HSA contribution limit.
HSA “contribution” limits and the actual funding within these limits have two different timelines. Your HSA contribution eligibility limit ends the month prior to when your Medicare coverage begins, including its retroactive coverage feature, if applicable. The funding of your last HSA contribution is when you file your current tax year return, so you have until the due date of your return (plus extensions) to maximize your final prorated annual contribution funding. Be careful not to exceed your own prorated annual contribution limit.
It’s easy to inadvertently breech your HSA contribution limit in a year when your HSA contribution limit is prorated. Excess HSA contributions need to be corrected. The way to do this is by removing the excess contribution and its associated earnings before the date in which you file your tax return, including extensions. If this is done, of course be sure not to deduct the excess contribution on your tax return and you will avoid the 6% excess contribution excise tax.
If the HSA excess contribution is not corrected by the time you file your tax return, you still need to remove the excess contribution and its associated earnings as soon as possible and then amend the filed return(s) and pay the 6% excess tax, and possibly interest and penalties for underpayment of taxes due. This 6% excise tax applies to the excess contribution(s) and its associated earnings for each tax year the excess contribution(s) remain in your account. Be aware that amended tax returns are highly scrutinized by the IRS. Also, when tax return amendments are made, each tax year’s amended return restarts its 3-year open audit window. This situation really increases your vulnerability to multi-year tax audits. Even if everything else on the returns is fine, it could be a real time burner and costly for your tax advisors’ services. Its best to scrutinize your HSA eligibility, your contribution limits and funding each tax year before filing your return, especially the tax year your Medicare coverage begins.
To summarize, here is what you can, cannot, want, and need to do regarding an HSA when receiving Medicare coverage:
NO NEED to “cash out” your HSA account prior to enrolling in Medicare
CANNOT establish an HSA when covered by Medicare
CANNOT contribute the full year’s HSA limit when transitioning to Medicare
CAN maintain an HSA balance when on Medicare
CAN use your HSA funds tax free to pay uncovered medical expenses
CAN use your HSA funds tax free to pay Medicare Parts A, B, C & D premiums
CANNOT use your HSA funds to pay Medicare Supplemental Insurance premiums
NEED to be aware of the HSA eligibility regulations
NEED to be aware of the HSA contribution limits and how they get prorated
NEED to be aware of the up to 6-month retroactive coverage of Medicare
WANT to be aware of how to correct HSA excess contributions
WANT to avoid paying excise taxes, unless necessary
NEED to monitor your HSA funding, especially the year in which you begin Medicare coverage or are covered by any non-HDHP