As you approach or enter retirement, managing healthcare costs becomes increasingly crucial in financial planning. Health Savings Accounts (HSAs) can be valuable tools in this regard, offering tax advantages designed to help cover medical expenses. According to a recent New York Times article, HSAs have seen significant growth, with approximately 36 million accounts holding over $116 billion as of 2023.1
For those unfamiliar with HSAs or needing a quick refresher, here’s how they work: You can contribute pre-tax dollars into an HSA, which can be withdrawn tax-free qualified medical expenses such as deductibles, copays, prescriptions, and other out-of-pocket costs (although there are some state-specific caveats regarding this tax treatment, as outlined below). Unused funds roll over year-to-year, allowing your HSA balance to grow over time.
To qualify for an HSA, you must be enrolled in an eligible high-deductible health plan (HDHP). For 2024, this means an eligible plan with a deductible of at least $1,600 for individuals or $3,200 for families. Contribution limits for 2024 are up to $4,150 for individuals and $8,300 for families, with an additional $1,000 catch-up contribution for those aged 55 and older.
Once enrolled in Medicare, you can no longer contribute to an HSA, although existing funds can still be used. If you delay Medicare enrollment and it is retroactively applied, any HSA contributions made during that period are treated as excess and may incur penalties.
Additional key details about HSAs include:
- State Tax Treatment: While HSAs are often described as being triple tax-free (contributions are tax-deductible, earnings grow tax-deferred, and withdrawals for qualified expenses are tax-free), this treatment does not apply across all fifty states. Specifically, California and New Jersey currently treat HSAs as regular bank or brokerage accounts and tax them accordingly.
- Investment and Fee Considerations: HSA plans can vary in terms of their underlying investment options and plan costs. Specifically, according to a recent report by the Consumer Financial Protection Bureau,2 HSA owners should be aware of the fees of their offered funds, as well as ongoing maintenance fees and exit costs, which can eat into the funds allocated for health care needs and, thus, reduce the benefits of tax savings. Also beware of parking money in low interest-bearing vehicles instead of (potentially) higher earning funds for longer-term growth; indeed, it has been reported that only 7% of all HSAs have funds in the latter.3
- Contribution Rules:
- Individual Ownership: An HSA can only be opened and owned by an individual. There is no such thing as a joint HSA for married couples.
- Family Coverage Contribution Options: If a married couple has a family health plan under one spouse’s name, they have two options for contributing to an HSA:
- Contribute the full family coverage contribution limit to one spouse’s HSA.
- Or, alternatively, divide the family coverage contribution limit between two separate HSAs, one for each spouse, in any proportion they choose.
- Catch-up Contributions for Age 55 and Older: If both spouses are aged 55 or older, they can each make an additional $1,000 catch-up contribution to their respective HSAs. However, if only one spouse has an HSA in their name, the $1,000 catch-up contribution can only be made to that spouse’s account; the other spouse will need to open a separate HSA to make their own $1,000 catch-up contribution.
- Contribution Deadline: While most people know that they can contribute to their HSA throughout the year, some may not realize that they can make contributions for the previous tax year up until the tax filing deadline, typically April 15th (or the next business day if April 15th falls on a weekend or holiday), similar to Individual Retirement Accounts (IRAs).
- Earned Income: Unlike IRAs and other retirement plans, you do not need to have earned income to be eligible for an HSA.
- Last-Month Rule: The so-called “last-month rule” for HSAs allows individuals to make the full annual contribution for that year if they are HSA-eligible on the first day of the last month of the tax year (December 1 for most taxpayers).This applies even if they were not eligible for the entire year, as long as they maintain HSA-eligibility for the following 12 months, known as the testing period. However, if they lose eligibility during the testing period, the excess contributions are subject to tax.
- Excess contributions: If you inadvertently contribute more than the annual applicable limit, the excess amount is subject to income tax plus an additional 6% penalty. However, the penalty can be waived if you withdraw the excess amount by that year’s tax filing deadline, including extensions. The excess amount will still be included in your taxable income, despite the penalty waiver.
Also note that any excess contributions remaining in an HSA can be deducted in future years, provided certain conditions are met. The IRS allows individuals to apply the excess contributions towards the contribution limit for a subsequent year, effectively treating the excess as a contribution for that future year. This method, known as the “future year method,” enables individuals to avoid the 6% excise tax on excess contributions by carrying them forward and deducting them from the allowable contribution limit for the next year. However, it is important to note that the amount carried forward counts towards the contribution limit for the future year, potentially reducing the amount that can be newly contributed. - Reimbursement Flexibility: According to IRS guidelines, there is currently no time limitation for reimbursing yourself from an HSA for qualified medical expenses. This means you can reimburse yourself at any time in the future for qualified medical expenses incurred after your HSA was established, even if it was years ago. However, you must keep detailed records and receipts to show the expenses were qualified medical expenses, were not reimbursed from another source, and were not claimed as an itemized tax deduction. The expenses must have been incurred after you opened and established your HSA account; you cannot reimburse expenses from before your HSA existed. When you reimburse yourself years later, you will receive a 1099-SA form from your HSA provider reporting the distribution. You must properly report this on IRS Form 8889 and be able to substantiate the qualified expenses if audited. Allowing funds to remain invested in your HSA and reimbursing yourself for past qualified expenses years later is a strategy some use to maximize the tax-free growth potential of the HSA. And, relatedly, unlike IRAs and other retirement accounts, HSAs do not have required minimum distributions (RMDs), so you can leave the funds in your account as long as you want.
- Erroneous withdrawals: Qualified medical expenses are those that would generally qualify for the medical and dental expenses deduction on your tax return; these are explained in IRS Publication 502 (“Medical and Dental Expenses”). If you mistakenly withdraw funds for an expense you thought was eligible but later realized was not, you can return the distribution to the same HSA by your tax return due date of the year following the year you knew or should have known about the mistake. This is considered a “mistaken distribution” by the IRS, and when returned in a timely manner, it is not subject to taxes or penalties. However, if the distribution was used for a clearly non-eligible expense, it cannot be returned as a mistaken distribution and would be subject to income taxes, and potentially the 20% penalty if you are under age 65.
- IRA to HSA Transfer: You can make a one-time transfer of funds from an individual retirement account to a health savings account (HSA), subject to certain rules and limitations. This is known as a “qualified HSA funding distribution.” There are some important nuances to bear in mind. First, you can only do this transfer once in your lifetime; in other words, it is a one-time opportunity. Second, the amount you transfer from your IRA to your HSA is limited to your annual HSA contribution limit for that year, minus any other contributions you have already made. Third, you must remain eligible for an HSA (i.e., enrolled in a high-deductible health plan) for the 12-month period following the transfer, known as the “testing period.” If you fail to maintain eligibility during this period, the transferred amount will be subject to income tax and a 10% penalty. Fourth, the transfer must be done as a direct trustee-to-trustee transfer from your IRA to your HSA. You cannot withdraw the funds first. And finally, the transferred amount is not tax-deductible, but it avoids being taxed as income when withdrawn from the IRA.
- Unused Funds in Retirement: Once you turn 65, you can withdraw money from your HSA for any purpose without a penalty (though you will pay income tax on non-medical withdrawals). This means that an HSA can function similarly to a traditional IRA or 401(k) in retirement if needed for non-medical expenses. If you are under the age of 65, you will incur a 20% penalty in addition to income tax.
- Long-Term Care Expenses: While HSAs cannot be used to pay for long-term care insurance premiums, they can be used to pay for qualified long-term care expenses, such as nursing home care, home healthcare services, and assisted living facility costs.
- Inheritance: In the event of the account holder’s death, an HSA becomes the property of the named beneficiary. If the beneficiary is a spouse, the account can be transferred tax-free and then used as the spouse’s own HSA. However, if an individual beneficiary is not the spouse, the account loses its HSA status, and the fair market value of the remaining corpus becomes taxable income to the beneficiary in the year of the original owner’s death. The beneficiary (other than the decedent’s estate) can reduce the taxable amount of the inherited HSA funds by deducting any payments made from the HSA for the decedent’s qualified medical expenses. This deduction is allowed for expenses paid within one year after the date of death. Furthermore, beneficiaries are not subject to the additional 20% penalty tax that typically applies to taxable HSA distributions taken before age 65.
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For those seeking more detailed information, IRS Publication 969 (“Health Savings Accounts and Other Tax-Favored Health Plans”) is a worthwhile resource. If you have any questions or need more clarification, please feel free to contact me.
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1. Ann Carns, “F.S.A. vs. H.S.A: What to Know About the Accounts That Pay Medical Costs,” New York Times, May 17, 2024.
2. Consumer Financial Protection Bureau, “Issue Spotlight: Health Savings Accounts,” May 2024.
3. The Kiplinger Tax Letter, June 6, 2024.