Participants in health savings accounts (HSAs) can use the funds in their plans to pay for qualified medical expenses for themselves, their spouses, and dependents.
Distributions from the plan for this purpose are not taxable to the participants.
Qualified medical expense means any expense eligible for an itemized medical expense deduction under Code Section 213(d).
This is a very broad category of expenses including some items that are almost never covered under health insurance, such as special schools for children with psychological conditions or heated swimming pools for arthritics.
However, cosmetic surgery and over-the-counter drugs are not included. Finally, no more can be paid from the plan than the amount in the participant’s account.
HSA plan funds cannot be used to pay the employee’s share of health insurance premiums (co-pays). However, HSA distributions can be used to pay for the following:
- qualified long-term care insurance;
- COBRA continuation payments;
- health care while receiving unemployment compensation; or
- Medicare Part A or B; and
- certain other payments including employer-sponsored retiree health insurance premiums.
Individuals (not plan trustees or employers) are responsible for proving that amounts are paid for qualified medical expenses. While there is no standardized way of reporting these expenditures right now, the IRS is likely to provide a form for this purpose in the future.
The “doughnut hole”
An HSA plan together with its companion high-deductible insurance plan may have a “doughnut hole” in its coverage because of the gap between the maximum contribution level and the maximum out-of-pocket limit.
For example, if a family high-deductible insurance plan limits out-of-pocket expenses to the maximum of $14,300, and the family contribution for the year is $6,750 (2017 figures), there is a potential gap of $7,850 of uninsured expenses with no coverage from the HSA fund (assuming no carryovers from prior years in the HSA fund).
This amount must be paid out-of-pocket with no tax benefit except presumably the possibility of an itemized medical-expense deduction under Code section 213.
Plans should be designed with this problem in mind.
Another similar issue arises when an individual incurs medical expenses that are below the deductible but exceed the amount in the individual’s HSA account. For example, this might happen in the early part of the year where the individual has been making monthly deposits for family coverage and the total in the HSA account is $800. If this individual incurs a $1400 medical expense, the $600 must be paid out of pocket.
And of course, since the expense is below the deductible, there is no insurance coverage.
These examples illustrate the point that there is no insurance as such in an HSA plan for expenses below the high deductible threshold.
Tax implications of contributions and distributions
Contributions
Contributions made by an individual are deductible above-the-line (that is, regardless of whether the individual itemizes deductions). An individual cannot double-dip by taking an itemized medical expense deduction for contributions or reimbursed expenses.
Contributions by the employer either directly or under a Section 125 cafeteria plan are deductible by the employer, not taxable to the employee, and not subject to FICA and FUTA taxes (Social Security and federal unemployment).
Contributions from Partnerships and S Corporations
Generally, the partnership can treat these amounts as partnership distributions or guaranteed payments.
If they are partnership distributions, they are not deductible to the partnership and do not affect the distributive shares of the partners. (That is, they don’t change the amount of partnership income taxed to any partner).
If they are treated as guaranteed payments, they are deductible to the partnership. These guaranteed payments are taxable to the partner who receives them, and are not excluded from income as part of a Section 106 accident or health plan. They are also included in the partner’s net earnings from self-employment for self-employment tax purposes.
S corporation payments to the HSA of a more than 2 percent shareholder follow the pattern of partnership guaranteed payments. They can be included in income of the shareholder, with no exclusion under Code section 106.
The shareholder is subject to FICA (regular Social Security tax) instead of the self-employment tax. However, FICA exceptions for sickness or accident payments may be available.
Distributions
An individual can make contributions to an HSA for a family member who is eligible—for example, a son or daughter who needs some financial support.
The eligible son or daughter, in this case, would take the deduction for the HSA contribution. However, as noted above, an individual who may be claimed as a dependent on another person’s tax return is not eligible for an HSA.
Distributions from an HSA are tax-free to the extent used to pay for qualified medical expenses, even if the medical expenses are paid at a time when the individual is not eligible for HSA coverage, for example after an individual has enrolled in Medicare.
Distributions other than for qualified medical expenses are taxable and subject to a 20 percent penalty. However, the 20 percent penalty does not apply if the distribution is made after the account beneficiary’s death, disability, or attainment of age sixty-five.
IRA rollovers
A taxpayer may, once in his lifetime, transfer money from an IRA to an HSA (called a qualified HSA funding distribution).
Because the transfer counts toward the taxpayer’s annual HSA contribution limit, it is not truly a rollover in the usual sense of the word. The qualified HSA funding distribution must be a trustee-to-trustee transfer from an IRA to an HSA in an amount that does not exceed the annual HSA contribution limitation for the taxpayer.
If the taxpayer fails at any time during the following tax year to be an eligible individual, he must include in his gross income the total amount of all qualified HSA funding distributions and pay a 10 percent penalty tax.