HSAs and Tax-Free Distributions

Health Savings Accounts (HSAs) are special accounts designed to pay for medical expenses with pre-tax money. When used for qualified medical expenses, owners of HSAs are able to take advantage of a triple tax free benefit: pre-tax contributions, tax-deferred growth, and tax-free withdrawals for qualified medical expenses.

With the pre-tax contribution, you contribute money directly from your paycheck to your HSA account before taxes are deducted. Some HSA accounts allow for the money in the account to be invested, and the money then grows from earnings gained from the money in the account being invested, and no taxes are paid on the earnings as they accumulate. Finally, as long as any money that is withdrawn from the HSA is used for qualified medical expenses, there will be no tax on those withdrawals. Also, as an additional added bonus, your employer may contribute funds into your HSA and that money is not includible in your gross income.

To be eligible and qualify for an HSA, you must be covered under a high deductible health plan (HDHP), have no other health coverage (some exceptions may apply), must not be enrolled in Medicare, and can’t be claimed as a dependent on someone else’s tax return.

Like other tax-advantaged investment accounts, there are annual contribution limits for HSAs. For 2020, a single person may contribute up to $3,550 (or $4,550 if age 55 or older), or a family may contribute up to $7,100 (or $8,100 if one spouse is age 55 or older or $9,100 if both spouses are age 55 or older).

QUALIFIED MEDICAL EXPENSES

As mentioned, money withdrawn from the account and used to pay for qualified medical expenses is tax free. Qualified medical expenses generally include the expenses listed in IRS Publication 502 for the medical expenses tax deduction. The expenses must be incurred primarily to alleviate or prevent a physical or mental defect or illness. Expenses that are merely beneficial to general health, such as vitamins, are not included. Some examples of qualifying medical expenses include annual physical exams, ambulance services, contact lenses, crutches, dental treatment, diagnostic devices, doctors’ fees, eye exams, fertility enhancement, hearing aids, home care, hospital services, and lab fees. Prescription medications, insulin, and over-the-counter medications prescribed by a doctor are also qualifying expenses. Insurance payments are also qualified if they are for long-term care coverage, health care coverage for an HSA owner who has reached age 65, and health care coverage during periods of coverage continuation (such as under COBRA) and periods during which an individual is receiving unemployment compensation.

If funds in an HSA are used for anything besides qualifying medical expenses then the funds are includible as income and taxable, and there will be a 20% penalty. There is an exception, and that is if you are age 65 or older or have become disabled. In either of those cases, taxes would still be applicable, but there would be no 20% penalty.

An important feature of HSAs is that the qualified medical expenses do not necessarily have to be incurred by the HSA owner. As long as an expense is not paid or reimbursed by any other source (such as the HDHP), HSA funds can be used to pay qualified medical expenses incurred by the HSA owner’s spouse, dependents whom the HSA owner claims on a tax return, and dependents whom the HSA owner could claim on a tax return, but the person filed a joint return, the person had a gross income of $3,950 or more, or the HSA owner, or his or her spouse if filing jointly, could have been claimed as a dependent on someone else’s tax return.

Even if an HSA owner becomes ineligible to receive or make contributions into an HSA, he or she may still use tax-free distributions from an existing HSA to pay qualified medical expenses at any time, as long as the expenses were incurred after the HSA establishment date.

HSA AS AN INVESTMENT VEHICLE

Increasingly, people are using the tax advantages of an HSA to save toward retirement. If you’ve already maxed out your 401(k) and IRA/Roth IRA contributions for the year, contributing to an HSA may be a good way to supplement retirement savings. Upon reaching age 65, HSA withdrawals get taxed in a way similar to Traditional IRA withdrawals, and without a penalty even if the expenses are not for medical purposes.

THE BOTTOM LINE

These are all important details to consider when you’re looking for a way to more efficiently pay for medical expenses, as well as when you’re looking for an additional investment vehicle that offers tax advantages. An HSA is a great solution for both situations.

The accompanying flowchart offers an easy way for you to determine if a distribution from your HSA this year will be tax- and penalty-free. It’s a free immediate download if you fill out the form.

If you would like help exploring HSA options or any other investment options feel free to...