Pay Attention to Your HSA

Are you overlooking or underutilizing your health savings account? How do you maximize the sacred triple tax benefit?

Due to the tax benefits, many individuals who can contribute to a health savings account (HSA) often choose not to use it for current health expenses. They instead prefer to maximize their annual contributions and use a long-term investment approach for the funds to either “let it ride” for payment of medical expenses after retirement or possibly with the intent of passing those tax-free benefits on to their heirs. Two great goals. However, these strategies can easily backfire if there isn’t a plan in place should the HSA outlive the owner.

Tax and Penalty for “Non-qualified” Distributions

Non-qualified HSA withdrawals are subject to federal and state income tax to the account owner. If the owner is under age 65, an additional 20% penalty tax is assessed. Ouch!

Tax-free withdrawals from the HSA can be made for non-reimbursable and non-deductible medical, dental, vision, prescription, and hospital expenses incurred after the account was opened. This also includes other, non-typical expenses such as over-the-counter treatments, chiropractic care, service animals, and more.

HSA reimbursement can be used for qualifying expenses incurred by the account owner, spouse, and children. Account-owners age 65+ can use the HSA for reimbursement of Medicare Part B, D, and Advantage premiums. A full explanation of what qualifies and who is eligible can be found in IRS Publication 502.

At age 65, distributions from an HSA for non-qualified expenses are still subject to tax; however, the 20% tax penalty no longer applies.

Your Beneficiary Matters

It’s important to name a beneficiary of your HSA and periodically review the designation to make sure it remains appropriate, particularly should you experience a life-changing event (divorce, illness, death of beneficiary).

• If the spouse is the beneficiary, the HSA will remain as is, and the spouse can use it with the same tax-free benefits.
  
  
• If the beneficiary is a non-spouse individual, the account loses its HSA status and will be fully disbursed to the beneficiary at the owner’s passing. In this situation, 100% of the disbursement is taxable to the beneficiary. Exception: if the beneficiary personally pays for the deceased account owner’s unpaid HSA-qualified medical bills within one year after his/her death, HSA funds used for those expenses are excluded from taxation.
  
  
• Suppose there is no beneficiary named, or the beneficiary is the owner’s estate. In that case, the HSA must be fully disbursed to the account owner’s estate and will be 100% taxable to the account owner on his/her final tax return.

“Superfunding” the HSA

If you’re maximizing HSA contributions and deferring reimbursements until after retirement, be careful. You must keep all receipts from qualifying expenses that occurred after opening the account that you’ve personally paid and not deducted on Schedule A for taxes.

Having proof of these expenses allows for a lump sum, tax and penalty-free distribution of the total amount later, even years later. (Know that you won’t be asked for these receipts when making the withdrawal; however, you must keep them in case you get audited by the IRS.)

This strategy works nicely if one’s plan for a long, healthy retirement goes uninterrupted by an unexpected death or terminal illness. If the unfortunate outcome occurs, however, and the account beneficiary is not a spouse, the beneficiary will realize a potentially sizable amount of taxable income.

Minimizing or Avoiding Forced Distribution

Strategies for spending down the HSA if an unexpected diagnosis occurs:

• Tally the total of all receipts on file for non-reimbursed, non-deducted qualifying healthcare costs since the account was opened and take a lump distribution for the amount.
  
  
• If the spouse is the beneficiary, consider taking a partial distribution and allowing the spouse to inherit the balance in case they cannot use all the HSA funds before passing away.
  
  
• If the child(ren) is beneficiary, take all that you can tax-free, then let the balance pass to the child(ren). Or, if your tax bracket is lower than the beneficiary’s, take full distribution of the account even if there are no qualifying expenses for the tax-free benefit. (In this situation, those under age 65 must also take into consideration the 20% penalty tax.)

Summary

If your health plan qualifies for the HSA, it’s advantageous to take full advantage of its triple tax benefit. If you “superfund” the account with no intention of using it before retirement, keep all receipts from qualifying expenses to enjoy tax-free withdrawals later, and don’t forget to review your beneficiary designation often. Doing these things will provide options for passing on the tax-free benefits to heirs if life throws you a curveball.

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