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HSA Basics: What Is It and Who Can Use It

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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.

Q: What is a health savings account (HSA) and who is eligible?

An HSA is a trust created exclusively for the purpose of paying qualified medical expenses of an account beneficiary.

An HSA must be created by a written governing instrument that states:

(1) no contribution will be accepted except in the case of a rollover contribution unless it is in cash or to the extent that the contribution, when added to previous contributions for the calendar year, exceeds the contribution limit for the calendar year;

(2) the trustee is a bank, an insurance company, or a person who satisfies IRS requirements;

(3) no part of trust assets will be invested in life insurance contracts;

(4) trust assets will not be commingled with other property, with certain limited exceptions; and

(5) the interest of an individual in the balance of his or her account is non-forfeitable.

HSAs are available to any employer or individual for an account beneficiary who has high deductible health insurance coverage. An eligible individual or an employer may establish an HSA with a qualified HSA custodian or trustee. No permission or authorization is needed from the IRS to set up an HSA. As mentioned above, any insurance company or bank can act as a trustee. Additionally, any person already approved by the IRS to act as an individual retirement arrangement (IRA) trustee or custodian automatically is approved to act in the same capacity for HSAs.

Although an HSA is similar to an IRA in some respects, a taxpayer cannot use an IRA as an HSA, nor can a taxpayer combine an IRA with an HSA.

Contributions to an HSA generally may be made either by an individual, by an individual’s employer, or by both. If contributions are made by an individual taxpayer, they are deductible from income. If contributions are made by an employer, they are excluded from employee income.

An HSA itself is exempt from income tax as long as it remains an HSA.

Contributions may be made through a cafeteria plan under IRC Section 125.

Distributions from HSAs are not includable in gross income if they are used exclusively to pay qualified medical expenses. Distributions used for other purposes are includable in gross income and may be subject to a penalty, with some exceptions.

An employer’s contributions to an HSA are not considered part of a group health plan subject to COBRA continuation coverage requirements. Therefore, a plan is not required to make COBRA continuation coverage available with respect to an HSA.

The IRS has stated that a levy to satisfy a tax liability under IRC Section 6331 extends to a taxpayer’s interest in an HSA. A taxpayer is liable for the additional 10 percent tax (20 percent after December 31, 2010, under PPACA 2010[12]) on the amount of the levy unless, at the time of the levy, the taxpayer had attained the age of sixty-five or was disabled.

Q: Who is an eligible individual for purposes of an HSA?

For purposes of an HSA, an eligible individual is an individual who, for any month, is covered under a high deductible health plan (HDHP) as of the first day of that month and is not also covered under a non-high deductible health plan providing coverage for any benefit covered under the high deductible health plan.

An individual enrolled in Medicare Part A or Part B may not contribute to an HSA. Mere eligibility for Medicare does not preclude HSA contributions.

An individual may not contribute to an HSA for a given month if he or she has received medical benefits through the Department of Veterans Affairs within the previous three months. Mere eligibility for VA medical benefits will not disqualify an otherwise eligible individual from making HSA contributions.

A separate prescription drug plan that provides any benefits before a required high deductible is satisfied normally will prevent a beneficiary from qualifying as an eligible individual. The IRS has ruled that if an individual’s separate prescription drug plan does not provide benefits until an HDHP’s minimum annual deductible amount has been met, then the individual will be an eligible individual under Section 223(c)(1)(A). For calendar years 2004 and 2005 only, the IRS provided transition relief such that an individual would not fail to be an eligible individual solely by virtue of coverage by a separate prescription drug plan.

An individual will not fail to be an eligible individual solely because the individual is covered under an Employee Assistance Program, disease management program, or wellness program, if the program does not provide significant benefits in the nature of medical care or treatment.

Certain kinds of insurance are not taken into account in determining whether an individual is eligible for an HSA. Specifically, insurance for a specific disease or illness, hospitalization insurance paying a fixed daily amount, and insurance providing coverage that relates to certain liabilities are disregarded.

In addition, coverage provided by insurance or otherwise for accidents, disability, dental care, vision care, or long-term care will not adversely impact HSA eligibility.

If an employer contributes to an eligible employee’s HSA, in order to receive an employer comparable contribution the employee must:

(1) establish the HSA on or before the last day in February of the year following the year for which the contribution is being made and;

(2) notify the appropriate contact person of the HSA account information on or before the last day in February of the year described in (1) above and specify and provide HSA account information (e.g., account number, name and address of trustee or custodian, etc.) as well as the method by which the account information will be provided (e.g., in writing, by e-mail, on a certain form, etc.).

An eligible employee that establishes an HSA and provides the information required as described in (1) and (2) above will receive an HSA contribution, plus reasonable interest, for the year for which contribution is being made by April 15 of the following year.

For more tax stories and Tax Facts Q&A’s, check out ThinkAdvisor’s 21 Days of Tax Planning Advice for 2014 Special Report.