Journal of Financial Planning: July 2018
Julie A. Welch, CPA, CFP®, PFP, is the director of tax services and a shareholder with Meara Welch Browne P.C. in Leawood, Kansas.
Cara L. Smith, CPA, CFP®, is a senior tax manager with Meara Welch Browne P.C. in Leawood, Kansas.
When advising your clients on ways to save money tax-free for future medical expenses, one thing to consider is a health savings account (HSA). To reduce the cost of medical care using HSAs, it’s imperative to understand the rules around them.
Health savings accounts (HSAs) are similar to individual retirement accounts (IRAs) for medical expenses. Both individuals and employers can contribute to HSAs for eligible individuals. HSAs are funded with pre-tax dollars, and distributions are tax-exempt if used for qualifying medical expenses. Like an IRA, HSA funds do not have to be spent in a calendar year and can be carried over in the plan balance indefinitely.
If a person is eligible, he or she can make deductible contributions to an HSA that is administered by a financial institution or insurance company. The money in the plan, which may be invested in certificates of deposit, stocks, bonds, mutual funds, and similar investments, grows tax-free. Distributions taken to pay for qualified medical expenses are tax-free. If a distribution is taken that is not used to pay for qualified medical expenses, there is tax plus a 20 percent penalty on the distribution amount. However, the 20 percent penalty will not apply if the person dies, becomes disabled, or reaches age 65.
To be eligible for an HSA, a person must meet several conditions. First, he or she must be covered under a high-deductible health insurance plan. For self-only coverage, the plan must have an annual deductible of at least $1,350 for 2018 and 2019, and annual out-of-pocket expenses (deductibles, copayments, and other amounts, but not premiums) not exceeding $6,650 (up to $6,750 for 2019). For family coverage, the plan must have an annual deductible of at least $2,700 for 2018 and 2019 and annual out-of-pocket expenses not exceeding $13,300 (up to $13,500 for 2019). Except for preventive care, the plan may not pay benefits until the person or the person’s family has incurred annual covered medical expenses in excess of the minimum annual deductible.
Second, the person may not be covered by any other health plan that is not a high-deductible health plan, including his or her spouse’s plan, his or her parent’s plan, or Medicare. However, the person may still be covered under workers’ compensation laws, insurance for the person’s auto and home, insurance for a specified disease or illness, insurance that pays a fixed amount per day of hospitalization, and insurance covering accidents, disability, dental care, vision care, or long-term care.
Third, the person may not be claimed as a dependent on another person’s tax return. This language is a little tricky for 2018 through 2025 where there is no deduction for dependents. The technical rule is that “no deductions shall be allowed to any individual with respect to whom a deduction under section 151 is allowable to another taxpayer for a taxable year beginning in the calendar year in which such individual’s taxable year begins.”
The Tax Cuts and Jobs Act set the exemption amount to zero for taxable years 2018 through 2025, but it did not eliminate dependents. So, if a person can be claimed as a dependent on another person’s tax return, that person is not eligible for his or her own HSA.
The Affordable Care Act (ACA) allows adult children up to the age of 26 to be included on their parents’ health insurance plans, regardless if the child is claimed as a dependent on the parents’ tax return, or if the child claims the dependency exemption for him or herself. For an adult child’s medical expenses to qualify for disbursement from their parent’s HSA, the adult child must be a dependent. Therefore, although the adult child may be included on the parents’ health insurance, HSA funds cannot be used to pay that child’s medical expenses unless the child is a dependent child.
Qualified Medical Expenses
Qualified medical expenses that can be paid using an HSA are those that would be deductible for tax purposes as medical expenses. This generally includes amounts that qualify for itemized deductions as medical expenses, such as medical plan deductibles, diagnostic services, long-term care insurance premiums, LASIK surgery, and some nursing services. Medicines and drugs are qualified expenses if they require a prescription, although there are some nuances to the prescription rule. If a drug is available without a prescription, such as an over-the-counter drug, but a prescription is obtained, expenses can be reimbursed from an HSA. Additionally, insulin is considered a qualified expense even though a prescription may not be required or given. Only certain health insurance premiums are considered qualified medical expenses, such as those paid in extenuating circumstances involving a job loss.
Qualified medical expenses may be for the person, the person’s spouse, or the person’s dependents, but reimbursed expenses cannot otherwise be covered by insurance. The HSA cannot pay health insurance premiums, since they are not qualified medical expenses under these rules. However, an HSA can pay for qualified long-term care insurance, COBRA health care continuing coverage, insurance coverage while receiving unemployment benefits, and the person’s or dependents’ premiums for Medicare Part B (medical coverage), Part D (prescription drug plans), or Part C (Medicare Advantage plans), but not Medigap plans.
Deductibility and Funding
A person may deduct a contribution to his or her HSA up to $3,450 for 2018 ($3,500 for 2019) for self-only coverage or $6,900 for 2018 ($7,000 for 2019) for family coverage. Note that the family deductible contribution was originally announced in Rev. Proc. 2017-37 as $6,900, but in March 2018 was lowered by $50 to $6,850 as a result of the Tax Cuts and Jobs Act that changed how the inflation adjustments were to be computed. However, to “avoid numerous unanticipated administrative and financial burdens” of lowering the amount by $50 partway through the year, in April the IRS announced in Rev. Proc. 2018-27 that the family deductible contribution amount would not be lowered and would in fact remain at $6,900 for 2018.
If the person is age 55 or older, he or she can contribute $1,000 extra to an HSA. Therefore, in 2018, someone 55 or older can contribute $4,450 for self-only coverage or $7,900 for family coverage.
Example: Connor is 40 years old, single, and self-employed. He is covered under a high-deductible health insurance plan. In January, he opens an HSA at his local bank by depositing $1,500, the annual deductible for his high-deductible health plan. He directs the bank to invest the $1,500 in a mutual fund, which has $100 of earnings for the year. During the year, he pays $700 for qualified medical expenses.
Connor can deduct the $1,500 he contributed to the account. He does not pay tax on the $100 earned from the mutual fund or the $700 he withdrew to pay for medical expenses.
Similar to IRAs, a person has until April 15 to make an HSA contribution for the previous year. If a person makes his or her HSA contribution between January 1 and April 15 of the following year, he or she must indicate that the contribution is to apply to the prior year or it will automatically be applied to the current year.
Once during a person’s lifetime, he or she may fund an HSA with a tax-free rollover from a traditional or Roth IRA, referred to as a qualified HSA funding distribution. The rollover amount is limited to the maximum deductible contribution to the HSA. This may be beneficial if a person does not have the cash to put into an HSA. A person may also be able to roll over amounts from flexible spending accounts and health reimbursement accounts into an HSA in certain circumstances.
Employers may contribute to an employee’s HSA and can pay the premiums for a high-deductible health plan on a deductible basis. An employer’s contributions are not taxable to the employee. Also, although cafeteria plans generally do not include deferred compensation plans, HSAs may be offered through cafeteria plans. This approach provides income tax and employment tax savings to the employee and the employer.
Coordination with Medicare
One area where we see mistakes is when a person becomes eligible for Medicare. As noted earlier, after a person enrolls in Medicare, he or she is no longer eligible to make contributions to an HSA because Medicare is not considered a high-deductible health plan. Medicare Part A (hospital insurance) is automatic and premium-free once a person turns 65 and begins receiving Social Security benefits, even if medical insurance benefits of Medicare Part B are not chosen. If Social Security benefits begin before age 65, for example in the case of disability benefits, Medicare Part A is not triggered because it is only applicable for those 65 and older, and contributions to an HSA are still allowed. Distributions from an HSA to pay for qualified medical expenses after enrolling in Medicare are allowed.
An individual may continue to make HSA contributions with respect to the months of the year before he or she becomes ineligible by means of enrolling in Medicare. If a person does make contributions after enrolling in Medicare, the excess contributions must be withdrawn. This also holds true if enrollment in Social Security, and therefore Medicare Part A, occurs after the month in which an individual turns 65, because he or she may be entitled to as many as six months of retroactive Social Security benefits.
The IRS is somewhat lenient when it comes to correcting excess HSA contributions. If the excess contributions (and any earnings associated with the contribution) are withdrawn before the due date of the person’s tax return, including extensions, then no penalty applies. However, the earnings on the excess contributions should be included in the account holder’s income in the year in which the distribution is received. This is true, even if the distribution is used to pay medical expenses.
If the contributions are withdrawn after the due date of the person’s tax return, including extensions, then an annual 6 percent excise tax/penalty tax is imposed. The tax is 6 percent of the cumulative amount of excess contributions that were not withdrawn from the HSA by the contributor. This 6 percent penalty is imposed each year in which the excess contributions remain in the account until the over-contribution is rectified. Form 5329, included with an annual Form 1040 filing, is used to calculate the 6 percent penalty along with Form 8889 to report the annual activity in the HSA.
Excess HSA contributions for a given year can be applied to contributions for the following year. This tactic applies only if the contributor is eligible for an HSA in the subsequent year. The deductible amount of any carryover contribution is limited to the annual HSA contribution maximum for the following year and is taken in the aggregate with any other current year contributions. Any excess left in the account at the end of the year is subject to the 6 percent excise tax.
Transfers Pursuant to Divorce or Death
If a couple gets divorced and an HSA is transferred to a spouse or former spouse pursuant to a divorce or separation agreement, the transfer is not taxable. The recipient spouse becomes the account beneficiary of the transferred HSA.
When an account beneficiary dies and the surviving spouse is the designated beneficiary, the surviving spouse is treated as the account beneficiary once the account is transferred. If the named beneficiary of an HSA is other than the owner’s spouse, the account will cease to be considered an HSA and be taxable to the beneficiary in the year of death. There is one exception in which heirs can use the HSA account balance to pay for the decedent’s eligible medical expenses that were not previously reimbursed by the HSA.
HSAs are a good way to get deductions for medical expenses, especially now that the majority of taxpayers will no longer itemize deductions and even for those who do, the deductible medical expenses are only those that exceed 7.5 percent of adjusted gross income (10 percent for 2019). Health savings accounts are also a good way to save money tax-free for future medical expenses.