As part of ThinkAdvisor's Special Report, 23 Days of Tax Planning Advice: 2016, throughout the month of March, we are partnering with our ALM sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.
How are funds accumulated in a Health Savings Account (HSA) taxed prior to distribution?
An HSA generally is exempt from income tax unless it ceases to be an HSA.
In addition, rules similar to those applicable to individual retirement arrangements (IRAs) regarding the loss of the income tax exemption for an account where an employee engages in a prohibited transaction and those regarding the effect of pledging an account as security apply to HSAs. Any amounts treated as distributed under these rules will be treated as not used to pay qualified medical expenses.
How are amounts distributed from a Health Savings Account (HSA) taxed?
A distribution from an HSA used exclusively to pay qualified medical expenses of an account holder is not includable in gross income. Any distribution from an HSA that is not used exclusively to pay qualified medical expenses of an account holder must be included in the account holder's gross income.
Any distribution that is includable in income because it was not used to pay qualified medical expenses is also subject to a penalty tax. The penalty tax is 10 percent of includable income for a distribution from an HSA. For distributions made after December 31, 2010, the additional tax on nonqualified distributions from HSAs is increased to 20 percent of includable income.
Qualified medical expenses are amounts paid by the account holder for medical care for the individual, spouse, and any dependent to the extent that expenses are not compensated by insurance or otherwise. For tax years beginning after December 31, 2010, medicines constituting qualified medical expenses will be limited to doctor-prescribed drugs and insulin. Consequently, over-the counter medicines will no longer be qualified expenses unless prescribed by a doctor after 2010. Interestingly, over-the counter non-drug medical expenses (bandages, contact lenses cleaner, blood pressure monitors, etc.) are still qualified without a prescription.
Planning Point:
Perhaps the most commonly question asked of HSA professionals is whether or not a particular expense in a particular set of circumstances is qualified or not. Even though there is an abundance of interpretative material, the question is sometimes difficult to answer. The IRS definition below provides a helpful summary interpretation of the law.
"Medical expenses are the costs of diagnosis, cure, mitigation, treatment, or prevention of disease, and the costs for treatments affecting any part or function of the body. These expenses include payments for legal medical services rendered by physicians, surgeons, dentists, and other medical practitioners. They include the costs of equipment, supplies, and diagnostic devices needed for these purposes.
Medical care expenses must be primarily to alleviate or prevent a physical or mental defect or illness. They do not include expenses that are merely beneficial to general health, such as vitamins or a vacation."
This definition can be helpful in cases where items can have dual purposes (a massage given in a hospital to revive an atrophied muscle is different than a massage given on vacation for pleasure).
With a number of exceptions, the payment of insurance premiums is not a qualified medical expense. The exceptions include any expense for coverage under a health plan during a period of COBRA continuation coverage, a qualified long-term care insurance contract, a health plan paid for during a period in which the individual is receiving unemployment compensation, or the payment of Medicare premiums (other than Medigap) after the age 65 and in some cases the employee portion of employer provided health insurance premiums after the age 65.
An account holder may pay qualified long-term care insurance premiums with distributions from an HSA even if contributions to the HSA were made by salary reduction through an IRC Section 125 cafeteria plan. Amounts of qualified long-term care insurance premiums that constitute qualified medical expenses are limited to the age-based limits found in IRC Section 213(d)(10) as adjusted annually.
An HSA account holder may make tax-free distributions to reimburse qualified medical expenses from prior tax years as long as the expenses were incurred after the HSA was established. There is no time limit on when a distribution must occur. HSA trustees, custodians, and employers need not determine whether a distribution is used for qualified medical expenses. This responsibility falls on individual account holders.
When may an account owner transfer or rollover funds into an HSA?
Funds may be transferred or rolled over from one HSA to another HSA or from an Archer MSA to an HSA provided that an account holder effects the transfer within sixty days of receiving the distribution.
An HSA rollover may take place only once a year. The year is not a calendar year, but a rolling twelve month period beginning on the day when an account holder receives a distribution to be rolled over. Transfers of HSA amounts directly from one HSA trustee to another HSA trustee, known as a trustee-to-trustee transfer, are not subject to the limits under IRC Section 223(f)(5). There is no limit on the number of trustee-to-trustee transfers allowed during a year.
A participant in a health reimbursement arrangement ("HRA") or a health flexible spending arrangement ("health FSA") may make a qualified HSA distribution on a one time per arrangement basis. A qualified HSA distribution is a transfer directly from an employer to an HSA of an employee to the extent the distribution does not exceed the lesser of the balance in the arrangement on September 21, 2006, or the date of distribution. A qualified HSA distribution shall be treated as a rollover contribution under IRC Section 223(f)(5), which means that it does not count toward the annual HSA contribution limit.
