Back in 2003, Congress introduced one of the best tax savings vehicles that exists to this day. It wasn’t the individual retirement account (IRA). It wasn’t the ever-popular Roth IRA. It was the often-overlooked health savings account (HSA), which provides taxpayers with an upfront tax deduction and tax-free and penalty-free distributions.
The tax rules surrounding HSAs were written to provide taxpayers with maximum flexibility in how to use these funds for medical expenses. As a result, strategic use of an HSA can lead to long-term tax savings opportunities.
Consulting a Certified Tax Planner is the best way to determine if an HSA should be part of your tax plan. Read on for an overview of HSA guidelines, little-known HSA rules that can benefit taxpayers, and examples of how an HSA can be used toward tax savings opportunities.
BASIC HSA RULES
Taxpayers can make a tax-deductible contribution to an HSA for a particular month if they meet these four criteria:
- The taxpayer is covered under a high deductible health plan (HDHP) on the first day of that month,
- The taxpayer is not covered by any other health plan that is not an HDHP (exceptions may apply for plans providing certain limited types of coverage),
- The taxpayer is not enrolled in Medicare (which generally means they have not reached age 65), and
- The taxpayer cannot be claimed as a dependent on another person’s tax return.
HDHPs are often called “HSA qualified plans” for easy identification. For a health insurance plan to qualify as a HDHP, it must meet certain requirements—namely, that the taxpayer bears the initial costs of medical care before the insurance provides coverage. The requirements for tax year 2022 are:
- For self-only coverage, a plan is considered a HDHP plan only if the annual deductible is at least $1,400 and the sum of the annual deductible and other out-of-pocket expenses for covered benefits (other than premiums) does not exceed $7,500, and
- For family coverage, a plan is considered a HDHP plan only if the annual deductible is at least $2,800 and the sum of the annual deductible and other out-of-pocket expenses for covered benefits (other than premiums) does not exceed $14,100.
- In 2022, the annual contribution limits are:
- $3,650 for an individual with self-only coverage, and
- $7,300 for an individual with family coverage.
Additionally, taxpayers aged 55 and over who are not enrolled in Medicare are allowed to contribute an additional $1,000 as a “catch-up” amount to help with retirement planning. If a taxpayer was only enrolled in a HDHP for part of the year, the amount they are allowed to contribute will be proportional to the number of months of HDHP coverage (unless the last month exception applies–-see next section).
One major benefit of the HSA deduction is that there is no income limit, which means that higher income taxpayers can benefit greatly from these funds. Also, HSA distributions that are used to pay for qualified medical expenses are both tax-free and penalty-free. This remains true even if the account beneficiary is no longer eligible for HSA contributions—say, if the individual is over age 65 and entitled to Medicare benefits or no longer has an HDHP.
For HSA purposes, qualified medical expenses must be:
- paid by the account beneficiary, their spouse, or their dependents
- used for medical care that would qualify for a medical expense deduction (but only to the extent the expenses are not covered by insurance or another means), and
- incurred after the HSA has been established.
Health insurance premiums are not considered qualified medical expenses except for qualified long-term care insurance, COBRA health care continuation coverage, or health care coverage while receiving unemployment benefits.
What about HSA distributions that are not used for qualified medical expenses? These withdrawals will be included in the taxpayer’s gross income and are subject to a 20% penalty. The penalty does not apply if the distributions are made after the account beneficiary reaches age 65, becomes disabled, or dies.
IMPORTANT HSA RULES FOR TAX PLANNING
In addition to the basic rules outlined above, taxpayers will want to pay special attention to the following provisions to get the most out of their HSAs:
Last Month Rule. If a taxpayer has HDHP coverage on the first day of the last month of the tax year (which is December 1st for most taxpayers), then they are considered an eligible individual for the entire year and can make the maximum HSA contribution.
Contribution by April 15th Rule. A taxpayer has until the unextended tax return due date for a calendar year to contribute to an HSA for that calendar year.
Once-in-a-Lifetime Rollover Rule. A taxpayer can move money from an IRA to an HSA once in their lifetime to fund the HSA. The maximum IRA-to-HSA rollover amount is equal to the annual maximum contribution amount for that year. The rollover must also be done during a calendar year that the taxpayer is eligible for an HSA contribution.
Delayed Reimbursement Rule. An HSA distribution in the current year can be used to pay or reimburse qualified medical expenses incurred in any prior year as long as the expenses were incurred after the HSA was established. There is no time limit on when the distribution must occur, but for the amount to be excluded from gross income, the account beneficiary must keep records showing that the distributions were used exclusively for qualified medical expenses, that these expenses had not been previously paid or reimbursed from another source, and that these expenses were not taken as an itemized deduction in any prior tax year.
Medicare Premiums Rule. While most health insurance premiums are not eligible for HSA reimbursement, the tax code does permit tax-free reimbursement of Medicare premiums.
While the combination of general HSA requirements and these special tax rules can make the planning process complex, you can enlist the help of a Certified Tax Planner to navigate the application of HSA-related rules.
EXAMPLES OF HSA STRATEGIES
Below are examples of how to leverage an HSA for tax savings in real world situations:
Scenario 1 — The Last Month Rule. On September 23, 2022, Randy lost his job and his employer-provided health insurance. On November 1, 2022, Randy enrolled in an HDHP family plan through December 31, 2022 and opened an HSA.
Since Randy has a family HDHP plan on December 1, 2022, Randy qualifies for HSA contributions under the last month rule. He can contribute $7,300 to his HSA up through April 15, 2023 (the due date of his 2022 tax return), apply it to his 2022 contribution, and take an above-the-line deduction on his 2022 Form 1040.
Scenario 2 — Delayed Reimbursement Rule. On May 1, 2022, Monique had an HSA with a $34,000 balance that she funded from contributions when she was younger. Monique now needs $10,000 to move forward with her plan to start a business. In tax years 2019, 2020, and 2021, both she and her dependent child had $11,000 of non-insurance out-of-pocket qualified medical expenses that she did not previously reimburse from her HSA or claim as a medical deduction.
Monique can distribute $10,000 from her HSA to reimburse prior qualified medical expenses and use the funds to capitalize her corporation. The HSA distribution will be both tax-free and penalty-free.
Scenario 3 — IRA-to-HSA Transfer. On March 1, 2022, Lian left her full-time job to become self-employed. Since she is just starting out, she operates the business as a sole proprietorship. On April 1, 2022, she signed up for a self-only HDHP with a monthly premium of $375.
During 2022, Lian spends $3,375 on HDHP premiums, and she can deduct these as self-employed health insurance premiums as an above-the-line deduction on her 2022 Form 1040. In addition, Lian can put $3,650 in her HSA for tax year 2022 in two ways:
- She can contribute cash directly and get an above-the-line deduction for contributions, or
- She can transfer it from her IRA and not include the transferred amount as income.
Lian decides to make a once-in-a-lifetime transfer from her IRA. While she will not get a deduction on her return, she also does not pay tax or penalty on the IRA transfer. The funds will now grow in the HSA tax-deferred.
A health savings account can be a powerful tool for tax savings optimization when the taxpayer is aware of the rules that apply. An HSA comes with the benefit of tax-deductible contributions and can come with tax-free and penalty-free distributions if the funds are used for qualified medical expenses.
To make the most of your HSA benefits and incorporate these special rules into your tax strategy, reach out to a Certified Tax Planner today!