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.  

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 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 (non-high-deductible) health FSAs or HRAs. As such:  

(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 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. 

What are the rules regarding moving money from an IRA to an HSA?  

The law allows individuals a one-time movement of IRA assets to fund an HSA provided: (1) they are eligible for an HSA, (2) they have a permitted IRA with sufficient funds, and (3) they have not already completed an IRA to HSA funding distribution.  The amount moved may not exceed the amount of one year’s HSA contribution limit. The technical term for this transaction is a “qualified HSA funding distribution,” not “transfer,” although the transaction is commonly referred to as a transfer.  

Planning Point:

The IRA funding option is important for HSA account holders with current or anticipated medical expenses and no source of funds for an HSA contribution other than an IRA. Taxpayers seeking to maximize contributions to tax deferred accounts are generally best served funding the HSA with new funds and preserving the IRA. Essentially, HSA account holders are trading one tax-favored account, the IRA, for another, the HSA. A person facing large medical expenses prior to having the time to build up an HSA balance is a candidate for funding an HSA with an IRA. This rule gives taxpayers a method to avoid paying taxes and penalties on an IRA distribution necessary to pay medical expenses.  

Some taxpayers will move IRA money to an HSA sooner than needed for medical expenses because the HSA is arguably a better tax-favored account than an IRA and they prefer to have their limited assets in an HSA. The key HSA benefit not available to IRAs is that the HSA can be used to pay for qualified medical expenses tax-free. A key benefit of an IRA, over an HSA, is the ability to access money for any reason at age 59 ½ rather than the age 65. HSAs also often provide less investment options and may charge higher fees.  

Moving money from a Roth IRA or non-deductible traditional IRA makes the choice more complex and often less desirable. Roth IRA contributions can already be withdrawn tax and penalty free at any time. Both Roth IRAs and nondeductible traditional IRAs contain basis that could be lost in a move to the HSA.  

A qualified HSA funding distribution relates to the taxable year in which the distribution is actually made.  This means that HSA account holders are not allowed to complete the transfers in the following year before their tax due date and have the contribution count for the previous tax year (regular HSA contributions can be made until the tax due date and are deemed to have been made on the last day of the preceding tax year for tax deductibility purposes).  

HSA account owners are not allowed to deduct the amount moved from an IRA to an HSA. The distribution from the IRA is treated as a “qualified HSA funding distribution” and is not subject to taxes or penalty (if an early withdrawal). HSA account owners do not pay taxes on the IRA distribution and they do not get to claim that tax deduction for the subsequent HSA contribution.  

The tax situation becomes more complicated if an individual moves money from a Roth IRA or a non-deductible traditional IRA with basis. The IRA to HSA rules allow the entire basis to stay with the IRA where it can be recovered at the time of distribution from the IRA. No basis transfers to the HSA. This is very favorable treatment, albeit a bit complex to track. If an individual does not have enough non-basis money in an IRA and still chooses to move the money into the HSA, the individual will lose the basis in that amount moved into the HSA.  

An IRA to HSA qualified funding distribution is generally not a good option for an IRA account holder that is taking a series of substantially equal periodic payments from an IRA (a method to avoid the early withdrawal penalty from an IRA). A qualified HSA funding distribution from an IRA that modifies the series of substantially equal periodic payments will result in the recapture rules applying to the payments made in the series prior to the qualified HSA funding distribution.  This rule will prevent most taxpayers that are in engaged in a series of substantially equal periodic payments from moving those IRA funds to an HSA.

See ThinkAdvisor’s complete tax planning home page: 23 Days of Tax Planning Advice: 2016.

Related: Mark Your Calendars: Key Tax Planning, Filing Dates in 2016