Health savings accounts (HSAs) provide a valuable tool for saving for both health-related and retirement expenses—however, many clients are unaware of the complications that arise with respect to HSAs once the client becomes eligible to enroll in Medicare. As a general rule, clients who are enrolled in Medicare are ineligible to also contribute to an HSA, but the interaction between Social Security and Medicare can make it easy for clients to inadvertently run afoul of the general rule—or miss out on ways to continue contributing to an HSA after 65.
The penalty taxes that can apply to ineligible HSA-contributors can be steep, so it is important for advisors to pay close attention to the timing rules to avoid turning a tax-savings strategy into a surprise tax bill.
HSAs: A Primer
To offset the cost of a high deductible health plan (HDHP), an individual (or his or her employer) is permitted to contribute $3,400 in pre-tax dollars to an HSA in 2017. For family coverage, the limit is increased to $6,750. Clients who are 55 and older are eligible to make an additional $1,000 per year catch-up contribution.
The funds are contributed pre-tax, and they can also be withdrawn tax-free if used to pay for qualified medical expenses. Although the term “medical expenses” covers a wide array of expenses (including Medicare premiums, vision and dental expenses, over-the-counter drugs and prescription costs), once a client reaches age 65, he or she can withdraw HSA funds for any reason without penalty. If the funds are withdrawn post-65 for non-medical expenses, those funds will be taxed at the client's ordinary income tax rate (as is the case for IRA withdrawals).
Much like a retirement account, earnings on the account value also grow tax-free. Importantly, the funds in an HSA do not expire from year to year, so the client can build up a substantial account balance over the years to help cover the cost of health coverage—or supplement retirement income if the client is lucky enough to escape large medical bills.
HSA Complications and Medicare
Unfortunately, once a client enrolls in Medicare Part A, he or she becomes ineligible to contribute to an HSA. Despite this, the funds that have already been contributed to the HSA can remain in the account and can be withdrawn tax-free. If the client's spouse has contributed to an HSA and enrolls in Medicare Part A, the client can open his or her own HSA and continue to contribute as long as he or she remains covered by an HDHP.
What many clients overlook, however, is that when a client begins collecting Social Security benefits, he or she must automatically sign up for Medicare Part A, and thus must cease making HSA contributions. If the client wishes to continue working after age 65, the client can defer Social Security benefits and, thus, defer Medicare Part A enrollment in order to continue contributing to an HSA.
Another consideration involves the six-month “look back” period during which the Social Security Administration provides six months' worth of back pay on the client's benefits retroactively from the time he or she begins collecting Social Security. This look back period can cause the client to become subject to penalty taxes on his or her HSA contributions unless those contributions end six months prior to Medicare enrollment.
Clients can specifically instruct the Social Security representative that they do not wish to receive the six months’ worth of retroactive benefits to avoid penalties on HSA contributions made in the six months prior to collecting Social Security. Clients who take this route should avoid enrolling online, and must instead either make a phone appointment or a face-to-face appointment at a Social Security office.
Both Medicare and HSAs can provide important benefits for clients, but the two generally do not mix, making it critical for advisors to pay close attention to the timing rules and remember that Social Security itself can trigger Medicare-related HSA ineligibility.
See these additional articles by Professors Bloink and Byrnes: