With all the changes in the health care arena over the past several years, the use of Health Savings Accounts (HSAs) is on the rise. The number of accounts has risen from 6.1 million as of January 2008 to an estimated 13.8 million at the end of 2014. These accounts generally operate as a savings/investment account that can only be used to pay for medical expenses on a pre-tax basis. However, there are many questions that remain about the impact HSAs have in terms of how they work, how they affect one’s health care, income taxes, how they compare to Flexible Savings Accounts and so on.
The driving force behind the increased use of HSAs is that many employers are transitioning from traditional health plans into high-deductible health plans (HDHP). In comparison to traditional health plans, HDHPs have lower premiums and higher deductibles (for 2015, at least $1,300 for single and $2,600 for family). An individual must be covered by an HDHP in order to participate in a Health Savings Account. Additionally, one cannot have other health coverage (limited exceptions), cannot be enrolled in Medicare and cannot be claimed as a dependent on another tax return.
HSAs give individuals the opportunity for tax-preferred treatment on money saved for medical care and are available to both employees and self-employed individuals. If you are an employee, you and/or your employer can make contributions. The annual limits for contributions vary depending on the type of HDHP coverage, age, date eligible and date you cease to be eligible. For 2015 the contribution limits are $3,350 for self-only and $6,650 for family (with an additional $1,000 for individuals who reach age 55 by the end of the year). Any contribution made by an employer reduces the amount that the employee can contribute personally. Contributions for the calendar year can be made up until April 15th of the following year. HSA contributions made by an individual’s employer or contributions made by an employee through a salary reduction are treated the same as a cafeteria plan contribution and are not includible in income. Therefore contributions are made with pre-tax dollars.
Medical expenses paid out of the HSA are not tax deductible. Contributions by self-employed individuals or those which are not contributed through a salary reduction are treated as an adjustment to adjusted gross income on the tax return. Contributions made by a partnership or S corporation to a partner’s or shareholder’s HSA are generally treated as compensation includible in income. However, any contributions are deductible by the partner or shareholder as an adjustment to adjusted gross income.
Excess contributions are generally subject to a 6% excise tax and are includible in gross income. The excise tax may be avoided if, in the same calendar year, the excess contribution and any income earned on the excess contribution is withdrawn prior to the timely filing of your tax return.
Distributions from HSAs can only be used to pay for qualified medical expenses and only those incurred after the plan has been established. Qualified medical expenses are any medical expenses that would otherwise be an itemized deduction including doctors, dentists, prescriptions, vision care, and hospital and lab fees. An exhaustive list can be found in IRS Publication 502, Medical and Dental Expenses. For good recordkeeping, individuals should retain support for any distributions taken from the HSA in the event that they are challenged by the Internal Revenue Service. Distributions not used for qualified medical expenses are includible in income and subject to a 20% additional tax, unless made after the beneficiary turns 65, dies, or becomes disabled.
Unlike a Flexible Savings Account, there is no limit as to the amount of funds that can remain in the account from year to year. The funds can be used or accumulate over time. Another advantage of the HSA when compared to a Flexible Savings Account, is that the account holder has the flexibility and control of investing the funds in the account. Therefore funds not used for medical expenses can be invested similar to any tax deferred account.
As part of a yearly review, individuals should examine the balance in their existing HSA account and estimate next year’s medical expenses to help determine what their following year contributions to the plan should be, while being mindful of the annual contribution limits.
With a limited exception, an individual may make a once-in-a-lifetime qualified HSA distribution directly from his or her IRA to his or her HSA. The amount is subject to the annual maximum HSA contribution limits. The IRA distribution is not taxable and can be applied toward the individual’s required annual IRA minimum distribution amount. The amount contributed would not be deductible as an HSA contribution.
If you participate in a Health Savings Account, Form 8889 will need to be completed as part of your federal tax return each year. This form summarizes:
- Type of plan
- Contributions made
- Employer/salary reduction
- Excess contributions
- Total distributions
- Qualified medical expenses
- Taxable distributions
- Any additional taxes
Health Savings Accounts give individuals more responsibility in monitoring and maintaining their health care coverage. Individuals should carefully consider the use of HSAs based on their particular situations. They offer tax advantages as well as substantially reduced insurance premiums, but are subject to high out-of-pocket costs before reaching annual deductibles. There are many issues to consider when instituting a Health Savings Account.