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George F. Bearup, J.D. Senior Legal Trust Advisor

May 6, 2022

Health Savings Accounts – A New Retirement Savings Strategy?

Health Savings Accounts (HSAs) are a great way to cover medical and long-term care costs in the owner’s retirement years when those expenses increase exponentially with the owner’s age. The only real tax drawback to accumulating wealth in an HSA is when the account is inherited after the account owner’s death by a non-spouse beneficiary.

It has been documented that HSAs increased by 6% in 2020. The number of HSAs now exceed 30 million. 71% of HSAs have been opened since 2015. More than $24 billion is now held in HSAs nationwide. These numbers suggest that millions of HSA owners look at their accounts as long-term wealth accumulation accounts, more than just a tax-favored way to pay for their future health, medical and long-term care expenses.

Advantages

An excellent summary of the advantages of an HSA was provided by Rosalice Hall in the October 2021 Perspectives. The benefits of an HSA can be summarized as follows:

  • HSA contributions are income tax deductible, regardless of the owner’s income level or whether the owner claims the standard income tax deduction or itemizes his or her income tax deductions.
  • There are no adjusted gross income (AGI) phase-out limits associated with an HSA contribution, unlike IRAs or Roth IRAs.
  • Contributions can be made to an HSA by more than just the owner; family members can also contribute to an HSA.
  • Moreover, the owner can claim an income tax deduction for contributions not only made by the HSA owner but also for contributions made by a family member to the account.
  • Like any IRA, contributions to an HSA grow income tax deferred.
  • Maintaining an HSA through the owner’s employer will cause the contributions to the account to not be subject to Medicare or Social Security withholding taxes.
  • Like a Roth IRA, distributions from an HSA are tax-free if the distribution is used to pay for qualified medical expenses, which are broadly defined to include long-term care insurance premiums and expenses. [See IRS Publication 502, Medical and Dental Expenses.]
  • Unlike a flexible spending account (FSA) the funds held in the HSA are not subject to a ‘use it or lose it’ rule at the end of a calendar year.
  • Under the CARES Act, even over-the-counter mediations are now eligible qualified medical expenses, which includes the cost of face masks, hand sanitizers and sanitizing wipes.
  • If the HSA owner’s spouse is designated as the beneficiary of the HSA, then the surviving spouse can continue to use the HSA for tax-free medical and long-term care expenses without any income tax consequences.
  • A one-time transfer rule exists that permits funds held in an HSA to be transferred to the owner’s IRA; however, the amount transferred is only up to the maximum amount that can be contributed to a traditional IRA for that year.
  • Mileage expenses incurred by the HSA owner to visit a physician or medical facility and to pay for lodging if the owner receives medical care in another city that necessitates an overnight stay away from home are also considered qualified medical expenses.

Disadvantages

There are some drawbacks to opening and maintaining an HSA.

In order to be able to make contributions to an HSA, the account’s owner must meet several eligibility requirements that include that the account owner: (a) must be enrolled in a high deductible health plan in order to make a tax deductible contribution; (b) cannot have any other health insurance that is not a high deductible health plan; (c) cannot be enrolled in Medicare or Tricare; (d) cannot have received care from the Veteran’s Administration within the prior 3 months; and (e) cannot be eligible to be claimed as a dependent on another person’s income tax return.

No ‘catch-up’ contributions to an HSA are allowed after its owner has attained age 65 and qualifies for Medicare.

Distributions from an HSA that are not used to pay qualified medical expenses will be subject to ordinary income taxation unless the distribution is due to the owner’s death or disability.

If funds are withdrawn from an HSA for non-medical purposes prior to age 65 years, the distribution will not only be taxable but it will be subject to a 20% penalty, but if the owner is over the age 65 there will be no penalty.

An HSA can be audited by the IRS, so the owner will have to retain receipts for all purchases for medical and health expenses when using their HSA as the source of funds.

If the HSA owner does not stop contributing to their account within six months before he or she applies for Social Security benefits, taxes and penalties will apply.

After the owner’s retirement, while HSA funds can be used to pay for Medicare or Medicare Advantage plan premiums, they cannot be used to pay for Medigap policy premiums.

Just like a traditional IRA, HSA funds can be rolled over to a new HSA only once every 365 days. In addition, the rollover is subject to the 60-day limit as the maximum amount of time in which the rollover must be completed.

The biggest drawback is if a non-spouse is designated as the beneficiary of the owner’s HSA when the owner dies, at which point the decedent-owner’s HSA ceases to be tax-favored. On the deceased HSA owner’s death, the HSA account will be immediately transferred to the designated beneficiary which then becomes taxable as ordinary income to the non-spouse beneficiary.

There is one important exception to the ‘immediately taxable’ rule when a non-spouse beneficiary inherits an HSA. Up to 12 months after the HSA owner’s death, qualified but unpaid medical expenses of the deceased owner can be paid from the distributed account; if the funds are used to pay those expenses, the amount will not be included in the non-spouse inheritor’s taxable income.

Note: If there is no spouse named as the designated beneficiary of the decedent’s HSA, the account owner might consider naming a charity as the designated beneficiary of the HSA. In the absence of a designated beneficiary, the account balance will be included in the owner’s estate as taxable income, on which taxes will be assessed.

Dependent Expense Confusion

Some ambiguity exists when it comes to whose medical care expenses can be paid income-tax-free from an HSA. Individuals do not have to be covered under the same health insurance policy that the HSA owner has, yet in other situations, the HSA owner cannot use his or her HSA to pay for medical care for an individual who is covered under the owner’s medical insurance plan. This confusion stems from HSA eligibility rules.

To use HSA funds for a dependent’s medical expenses, the dependent must specifically be claimed as a dependent on the HSA owner’s income tax return. Because of this requirement, a scenario could exist where an HSA owner’s adult dependents who are working and who file their own income tax returns are nonetheless covered by the owner-parent’s high deductible medical plan. In that situation the owner’s HSA cannot be used to pay for medical expenses for those covered dependents who file their own income tax returns.

For example, suppose the owner’s 24-year older daughter is employed and files her own Form 1040 income tax return. This means that the daughter is not eligible to be claimed as an income tax dependent on her parents’ Form 1040 income tax return. The daughter may be enrolled in her parents’ qualified high deductible health insurance plan until she attains age 26, but her parents’ HSA cannot be used to cover their daughter’s medical expenses. Since the daughter’s medical expenses cannot be paid from her parents’ HSA, she may need to establish her own HSA for her own medical expenses. Because the daughter is covered by her parents’ high deductible health insurance plan, she will be able to open her own HSA which allows her to contribute up to the maximum family contribution of $6,750 to her HSA. Accordingly, the parents could contribute up to $6,750 to their HSA, and their daughter could contribute another $6,750 to her own HSA, and the parents could be the source of funds for the contribution to their daughter’s HSA with an annual exclusion gift to her.

There is a growing popularity in opening and saving for retirement through HSAs. Because the HSA is such a valuable opportunity to make investments with all of these tax savings benefits, a danger exists that some HSA owners might forgo necessary medical care simply to avoid depleting their HSA to pay those current medical expenses. While some view an HSA as a supplement to their retirement savings, the clear purpose of the HSA account, which is to pay for medical expenses tax-free when needed, should not be forgotten.

If you are interested in establishing an HSA, you might want to read the Morningstar “2017 Health Savings Account Landscape” to learn what fees various providers charge to maintain an HSA. Another source of information is HealthEquity’s blog post: “How much does an HSA cost?” to determine how much you might actually save in income taxes if you contribute to an HSA. There are tax-savings calculators at: www.hsacenter.com/hsa-calculators.html.