As part of ThinkAdvisor’s Special Report, 21 Days of Tax Planning Advice for 2014, throughout the month of March, we are partnering with our Summit Professional Networks 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.
Includable distributions received after an HSA holder becomes disabled within the meaning of IRC Section 72(m)(7), dies, or reaches the age of Medicare eligibility are not subject to the penalty tax.
Qualified medical expenses are amounts paid by the account holder for medical care for the individual, his or her 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.
With several 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 or a health plan paid for during a period in which the individual is receiving unemployment compensation.
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), that is, it does not count toward the annual HSA contribution limit.
If an employee fails to be an eligible individual at any time during a taxable year following a qualified HSA distribution, the employee must include in his or her gross income the aggregate amount of all qualified HSA distributions. The amount includable in gross income is also subject to a 10 percent penalty tax.
General purpose health FSA coverage during a grace period, after the end of a plan year, will be disregarded in determining an individual’s eligibility to contribute to an HSA if the individual makes a qualified HSA distribution of the entire balance. Health FSA coverage during a plan year is not disregarded, even if a health FSA balance is reduced to zero. An individual who begins HDHP coverage after the first day of the month is not an eligible individual until the first day of the following month.
The timing of qualified HSA distributions therefore is critical for employees covered by general-purpose, that is, non-high-deductible, health FSAs or HRAs:
(1) An employee only should make a qualified HSA distribution if he or she has been covered by an HDHP since the first day of the month;
(2) An employee must rollover general purpose health FSA balances during the grace period after the end of the plan year, not during the plan year, and, of course, he or she must not be covered by a general purpose health FSA during the new year; and
(3) An employee must rollover the entire balance in an HRA or a health FSA to an HSA. If a balance remains in an HRA at the end of a plan year or in a health FSA at the end of the grace period, the employee will not be an HSA-eligible individual.
Beginning in 2007, a taxpayer may, once in his or her lifetime, make a qualified HSA funding distribution. A qualified HSA funding distribution is 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 a taxpayer has self-only coverage under an HDHP at the time of the transfer, but at a later date during the same taxable year obtains family coverage under an HDHP, the taxpayer may make an additional qualified HSA funding distribution in an amount not exceeding the additional annual contribution for which the taxpayer has become eligible.
If a taxpayer fails to be an eligible individual at any time during a taxable year following a qualified HSA funding distribution, the taxpayer must include in his or her gross income the aggregate amount of all qualified HSA funding distributions. The amount includable in gross income also is subject to a 10 percent penalty tax.
Can an individual’s interest in a Health Savings Account (HSA) be transferred as part of a divorce or separation?
An individual’s interest in an HSA may be transferred without income taxation from one spouse to another or from a spouse to a former spouse if the transfer is made under a divorce or separation instrument. Following this kind of transfer, an interest in an HSA is treated as an interest of a transferee spouse.
What happens to a Health Savings Account (HSA) on the death of an account holder? May a surviving spouse continue an account?
The disposition of an HSA at the death of an account holder depends on who is the designated beneficiary. If an account holder’s surviving spouse is a designated beneficiary, then, when an account holder dies, the surviving spouse is treated as the account holder.
If an account holder’s estate is a designated beneficiary, the fair market value of the assets in the HSA must be included in such beneficiary’s gross income for the estate’s last taxable year. A deduction for any federal estate taxes paid is allowed to any person other than a decedent or a decedent’s spouse under IRC Section 691(c) with respect to amounts included in gross income by that person.
If anyone other than a surviving spouse or an account holder’s estate is a designated beneficiary, the account ceases to be an HSA as of the date of the account holder’s death and the fair market value of the assets in the account must be included in the designated beneficiary’s gross income for the year including the date of death. The amount that must be included in gross income by any person other than the estate is reduced by the amount of qualified medical expenses that were incurred by the decedent account holder before his or her death and paid by the designated beneficiary within one year after the date of death.
For more tax planning stories, check out our Special Report 21 Days of Tax Planning Advice for 2014 home page.