Health Savings Accounts
Health Savings Accounts (HSAs) have become a popular option in the medical benefits arena. Most people are familiar with the basics of how the HSA works- you contribute money into the account, get a deduction for the contribution, earn tax free growth and get tax free reimbursements for qualified medical expenses. However, there are some details you should know about HSAs or you may find yourself making non deductible contributions or subject to penalties.
First, to be eligible for an HSA you must be covered under a high deductible health plan (HDHP), have no other health coverage (with the exception of certain coverages permitted by the IRS), not be enrolled in Medicare, and not be claimed as a dependent on another taxpayer’s return. If you are a dependent you are not allowed to take a deduction for your HSA contributions, even if the other person does not claim you as a dependent on their tax return. If you are married, one spouse can have an HSA even if the other spouse has non-HDHP coverage, provided the first spouse is not covered by the non-HDHP coverage. If both spouses are eligible for an HSA, they must open separate accounts. There is no such thing as a joint HSA account, although one spouse may have family coverage. To further complicate matters California does not recognize HSAs. This means that contributions are non-deductible, income earned in the HSA is taxable, and employer provided HSA amounts are taxable.
Next, let’s look at contributions to your HSA. For 2010 you can contribute $3,050 if you have self-only coverage and $6,150 if you have family coverage. If you were not covered by an HDHP for the entire year, you can generally contribute the maximum as long as you were covered on the first day of the last month of the year and continue to be covered for one full year. If you are over the age of 55 your contribution limit is increased by $1,000. It’s important to remember that the contribution limits are the maximum per year, not per HSA account or per person. If you have more than one account, the contributions in total to all accounts cannot exceed the maximum contribution allowed without being subject to a penalty. Contributions made by your employer that are excluded from your taxable income count toward your annual maximum contribution. Finally, married taxpayers where both spouses have separate family HDHP plans are treated as having one family plan and are therefore limited to a maximum contribution of $6,150. The same is true if one spouse has self-only coverage and the other spouse has family coverage. Contributions can be made until the due date of the individual’s tax return, excluding extensions. Keep in mind that contributions in excess of the allowable amounts may be subject to a 6% penalty.
Distributions taken from your HSA to pay for qualified medical expenses are tax free. Distributions taken for any other reason are taxable and may be subject to a 10% penalty. There are also situations in which a taxable deemed distribution can result, such as if your HSA is used as security for a loan or is engaged in any prohibited transactions such as the sale, exchange, lease or loan of property held in the HSA to the account holder. These deemed distributions are also taxable and subject to the 10% penalty. HSA administration and maintenance fees are not considered distributions. Furthermore, the income earned within the HSA is not taxable.
Make no mistake about it; the rules for HSAs are complex. But the triple tax advantage (deductible contributions, income tax-free, tax-free distributions) of HSAs can almost be too good to ignore. Many HSA custodians also permit your HSA funds to be invested in mutual funds, equities, and other securities. Effectively your HSA can be used as a tax-free retirement vehicle to be used for medical expenses down the road. Since there are no income limits to the deductibility of contributions, this is a tax break that even us “wealthy” California taxpayers can take advantage of.
With proper planning a maxed out HSA account may make more sense than long-term care insurance coverage or life insurance or annuities. There are also numerous non-tax considerations to make regarding HSAs as well.
While this article expands upon the basics of an HSA, there are many more questions that can arise when dealing with HSA transactions. What happens if the HSA account holder dies? What about medical expenses incurred and paid on behalf of a child of divorced parents? What if you close your HSA account? Medical benefits transactions have tax consequences and it’s important to keep your tax preparer in the know about your HSA transactions to maximize the tax benefits and reduce the potential for penalties. Talk to your LMGW advisor today to make sure you know all the facts about the tax benefits and consequences of an HSA.
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