TAXATION OF HEALTH SAVINGS ACCOUNTS
Health Savings Accounts, or HSA's are one of the most tax efficient vehicles available to taxpayers. You fund your HSA with tax deductible, or pre-tax dollars. Your investment returns are tax deferred, and if the distributions are used for qualified medical expenses these distributions are tax free. This is a triple tax-free vehicle, i.e., the contributions, earnings, and distributions. From a tax perspective, this makes HSAs more tax efficient than an IRA or 401(k) account. These are true savings accounts intended for future medical expenses, not the old use-it-or-loose-it medical accounts.
You are not required to use the funds in these accounts each year, so the investments within the account will continue to grow tax deferred. If you are healthy, or otherwise able to meet your medical plan deductible with other funds, HSA’s can be an integral part of your retirement plan. This situation provides you with a longer investment time horizon, therefore you could invest aggressively and accumulate a substantial nest egg to be part of your medical expense budget when in retirement. At that time, most likely your consumption of health care services will be much higher than when you are younger.
HSA Eligibility – the taxpayer must:
Be covered by a High Deductible Health Plan, referred to as HDHP
Have no other health insurance coverage except the HDHP
Not be enrolled in Medicare
Not be claimed as a dependent on someone else’s tax return
A HDHP is any plan that has a deductible falling between the minimum and maximum annual amounts. For tax year 2022:
The annual HSA contribution amounts are limited, and these limits are indexed for inflation on an annual basis by the IRS. For tax year 2022 the contribution limits are:
An individual who qualifies for an HSA as of the first day of the last month of the year (December 1st for calendar year taxpayers) is an eligible taxpayer for the entire year. HSA contributions can be made at any time during the tax year and up to the due date of the tax return, plus extensions. Be careful not to exceed the contribution limits in any tax year. These excess contributions are not deductible and if not distributed with their associated earnings from your account prior to the due date of the return, including extensions, a 6% penalty applies to the excess contributions.
For a self-employed taxpayer, while the HSA contribution is deductible for Federal income tax purposes, it remains subject to employment tax. The HSA contribution will not reduce self-employment earnings for purposes of calculating the maximum self-employed retirement plan contribution.
Distributions from HSAs used to cover qualified medical expenses for the taxpayer, the taxpayer’s spouse, or the taxpayer’s dependents are excluded from income. Qualified medical expenses almost follow the same definition as those eligible for deduction if a taxpayer itemizes deductions. The HSA definition exception is that medical insurance premiums are excluded unless these premiums are made available through COBRA benefits. Whereas HSA distributions used to cover long-term care premiums are allowed to be excluded from income.
Any distribution from an HSA (or Archer MSA) that are not used to pay for qualified medical expenses are subject in Federal income tax plus a 20% penalty (see exceptions below). Be careful in tracking your medical expense payments from your HSA as these reimbursements are netted against the medical expense, and therefore making the medical expense ineligible as an itemized deduction. See IRS Publication 502.
Once a taxpayer reaches age 65 the HSA funds may continue to be used for qualifying medical expense and not included in gross income. If at age 65 or older the HSA distribution are not used for qualifying medical expenses the 20% penalty no longer applies, although these distributions are subject to ordinary income tax. Other exceptions to the 20% penalty include distributions caused by the account owner’s death or disability.
From the estate planning perspective, you can pass your HSA to your surviving spouse who will enjoy the same tax-free treatment. Whereas a non-spousal beneficiary will include the disbursements from the HSA as ordinary income. Be sure to have your primary and contingent beneficiaries’ elections on file for this savings account to have the account transfer at death. This ensures that this asset will be transferred directly to your heirs without going through the estate probate process. This asset will be included in the accounting of your gross estate.