Can You Reimburse Non-Qualified Expenses from an HSA? If So, How?

Can You Reimburse Non-Qualified Expenses from an HSA? If So, How?

Health Savings Account work very differently from Health FSAs in some key areas. Reimbursements is one such area.

Many Americans are confused about whether the workplace medical reimbursement account in which they're enrolled is a Health Savings Account or a Health FSA. The two plans offer similar immediate tax benefits, though a Health Savings Account offers much more flexibility in time horizons, opportunities to increase balances, and products and services on which to spend accumulated funds.

The flexibility around distributions is a two-edged sword. Yes (spoiler alert . . .), you can withdraw funds from a Health Savings Account for non-qualified expenses. But this added flexibility means that your administrator isn't an ally when it comes to defining qualified expenses. You must know the rules to remain compliant with federal tax law.

Defining the Accounts

A Health Flexible Spending Account is an annual employer-sponsored reimbursement account through which participating employees make an annual election, fund the account with level pre-tax payroll deductions during the year, and reimburse a range of qualified medical, dental, and vision expenses. It generates tax savings for participants, but they face a risk that they elect too much or too little to cover their actual expenses. Their unused balances expire at the end of the year, although an employer can adopt one of two provisions give participants more time to spend remaining balances.

A Health Savings Account is a personal financial account, like a personal checking account. Many people establish their Health Savings Account through their employer, but it remains a personally owned account. It has no defined plan year. Unused balances roll over (again, like a checking account) to be spent in the future.

Distributions for Non-qualified Expenses?

Health FSA participants can't spend their elections on non-qualified expenses. The plan administrator must verify that all withdrawals are for qualified expenses. Debit cards are coded to restrict their use (more detail below), and several tools allow administrators to auto-substantiate most debit-card transactions so that participants don't have to send detailed receipts.

Example: Randall uses his Health FSA debit card at the dentist's office to buy a teeth-whitening system, which is considered cosmetic and therefore not a qualified expense. The debit card allows purchases at a dental office, but the administrator will inform Randall that he must submit paperwork to show what was purchased. When the administrator reviews the documentation and rejects the expense, Randall will have to reimburse his Health FSA with personal (after-tax) funds.

In contrast, Health Savings account owners can withdraw funds for any purpose, although distributions for non-qualified expenses are included in taxable income and, unless the owner is disabled or age 65 or older, subject to an additional 20% tax as a penalty.

Example: Sylvia uses her Health Savings Account debit card at the dentist's office to buy the same teeth-whitening system. Her debit card is coded to allow purchases at a dental office. Since Sylvia can use her account balance to purchase whatever she wants, the administrator won't ask for follow-up documentation. Sylvia alone is responsible for knowing which expenses are and aren't qualified. When she completes her tax return for the year of this purchase, she must either (1) match the withdrawal with another qualified expense that she didn't reimburse from her Health Savings Account or (2) include the transaction amount in her taxable income (and pay the additional 20% tax if applicable).

Same Seller, Different Tax Status of Purchases

Beware that sometimes you may purchase qualified and non-qualified items on the same transaction. In this case, the debit card typically won't be able to warn you of a potential compliance issue by denying the purchase.

Example: Sylvia (above) buys her teeth-whitening system on the same dental visit during which she pays her $50 deductible for a dental crown and puts down a $250 deposit on her share of the price of the crown. The dental crown is a qualified expense, but the teeth-whitening system isn't. The debit card will allow the purchase because the merchant is a dentist, most of whose goods and services are qualified. In this case, Sylvia must note in her tax records the portion of the transaction that's not qualified.

In this example, Sylvia may be able to bring herself back in compliance by paying some of or all the balance of the dental crown with personal funds to offset the cost of the teeth-whitening system (as explained in the first option in the previous example). Account owners don't report every transaction at tax time. Instead, they sum distributions for qualified and non-qualified expenses on Form 8889. That's why you (and Sylvia) can offset non-qualified expenses with purchases of qualified expenses made with personal funds to come back into compliance.

Coding Debit Cards

Health Savings Accounts may or may not be merchant-coded. This term refers to the merchant codes that businesses must select to identify their company as a furniture store, an optical shop, a gas station, or a restaurant in the card system. A best practice in the Health Savings Account industry is to merchant-code debit cards to limit their acceptance to locations that usually sell qualified goods and services (physician offices, pharmacies, imaging centers, chiropractor offices, dental offices, optical shops, etc.). This coding helps account owners manage their accounts by blocking them from inadvertently pulling out the wrong debit card at a clothing store, auto dealership, coffee shop, sports venue, or casino.

Withdrawing Funds for Non-qualified Expenses

But what if you want to withdraw funds from your Health Savings Account with the debit card at the casino or a restaurant?

Can you? The legal answer, as we've already noted, is yes. But the process of accessing the funds is usually complicated.

Most Health Savings Account debit cards, as noted, are merchant-coded. The seller can't override the merchant coding, which is hard-wired into the card service's technology platform. You can't call your Health Savings Account administrator and ask that the coding be removed for this one transaction.

So, how do you withdraw funds for a non-qualified expense?

The answer: Ask your administrator. Your Health Savings Account provider can't deny your request for a withdrawal for any reason. In fact, it's none of the administrator's business how you spend your money. Your account provider will never ask you for documentation to substantiate that an expense is qualified. It's your responsibility alone to track accurately your contributions, distributions, and earnings. Think about your bank, which doesn't track your withdrawals from your personal checking account for tax-deductible expenses (like mortgage payments and property taxes). You're responsible for knowing the tax implications of your financial transactions and reporting them properly when you file your personal income tax return.

Your administrator must provide at least one method of withdrawing funds for non-qualified expenses. Some administrators allow the card to be accepted at all merchant locations, so you can use it for any purchase. But uncoded cards represent a small percentage of total Health Savings Account debit cards.

In the early days of Health Savings Accounts, many administrators offered a checkbook. But paper checks are becoming a relic of a bygone era.

In most cases, your administrator will have a process through which you log into your online account or call the customer service area and request a distribution. If you've provided direct-deposit information for your personal checking or savings account, the money is electronically deposited quickly. If not, you're issued a paper check.

The Bottom Line

Yes, you can withdraw Health Savings Account balances for any purpose - not just for qualified expenses. But it's an expensive proposition. Not only do you pay taxes and possible penalties, but you also deplete your funds and leave less for qualified expenses in the future. And it's rarely as easy as simply swiping your Health Savings Account debit card at the point of purchase. Withdrawing funds for non-qualified expenses is not a best practice for account owners who want to maximize the financial and tax advantages that a Health Savings Account offers.

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