Distribution Tax Status When You're No Longer HSA-eligible

This column is an excerpt (Question 78) from a book to be published later this year to help guide account owners, employers, benefits managers, and administrators understand Health Savings Account compliance issues. The format consists of a common question, an explanation in easy-to-understand English (often with an appropriate example), and citation from government documents to support the answer. The book is designed to inform. It is not a legal document, and the contents should not be construed as legal advice.

What is the tax treatment of distributions from a Health Savings Account, both when I’m HSA-eligible and when I’m not?

Distributions for qualified medical expenses (see Question 80) are always excluded from taxable income once you’ve established your account. You face no tax consequences when you withdraw funds for services and items included on the Internal Revenue Service list of medical, dental, vision, and other expenses qualified for tax-free reimbursement.

It doesn’t matter whether you remain eligible to fund your Health Savings Account. Eligibility is relevant only to opening and funding your account. Once you’ve established your Health Savings Account (see Question 79), all withdrawals for qualified expenses incurred by qualifying family members are excluded from your taxable income.

Although Health Savings Accounts are designed to help you pay for qualified medical expenses, you’re permitted to make distributions at any time for any expense. Withdrawals for expenses that aren’t qualified are included in your taxable income, and subject to penalties if you’re not age 65 or older or disabled.

If your aggregate distributions for a year exceed the qualified expenses that you have incurred since you established your account and you haven’t reimbursed them from other sources, the excess withdrawals are included in your taxable income. Further, if you’re under age 65 and not disabled, you face a 20% additional tax.

Example 1: You withdraw $1,000 for a non-qualified expense. Your marginal tax rate (federal and state income taxes) is 28%, so you pay $280 in income taxes and an additional $200 (20% of $1,000) as a penalty, for a total of $480. You’re left with $520 after taxes and penalties. Viewed another way, you must withdraw more than $1,900 to pay the taxes and penalties and net sufficient funds to pay a $1,000 bill for a non-qualified expense.

Example 2: You withdraw $1,000 for non-qualified expenses. But during the three prior years that you have been HSA-eligible and contributed to your account, you paid for more than $1,000 of qualified expenses with personal funds, rather than Health Savings Account balances. You can pair those unreimbursed expenses (be sure you’ve retained documentation to substantiate that the expenses are qualified) with the $1,000 withdrawal to avoid taxes and penalties.

Like premature withdrawals from a retirement account, distributions from a Health Savings Account for non-qualified expenses are an expensive source of cash. Most account owners can (and should) tap other assets or borrow money to meet an immediate need at an interest rate much lower than the sum of applied taxes and penalties that they would pay for a distribution for a non-qualified expense from a Health Savings Account.

 Tips

Health Savings Account distribution activity is aggregate. Distributions for non-qualified expenses aren’t automatically subject to taxes and penalties. You sum your qualified expenses and withdrawals annually to determine whether you’re subject to taxes and penalties. If you incur unreimbursed qualified expenses (and remember, you can go back as far as when you established your account) that you can match dollar-for-dollar with distributions from the account, you face no taxes or penalties.

Example 3: You established your Health Savings Account in 2017. You withdraw $540 in April 2024 to purchase two tickets to opening day of the baseball season. You used your personal credit card to pay for $1,125 of dental work in 2018 because you wanted to earn your rewards. But you didn’t pay the credit-card bill with funds from your Health Savings Account. You can pair that $1,125 dental bill with your $540 withdrawal for a non-qualified expense to avoid taxes and penalties (and still have $585 to apply to another distribution).

 Some Health Savings Account owners worry that they’ll accumulate more money in their accounts than they’ll spend on qualified expenses in retirement. This concern may lead them to withdraw balances for non-qualified expenses when they turn age 65, since the penalty is waived beginning at age 65. But that’s not a good use of funds. Account owners are better off paying other expenses with distributions from a tax-deferred 401(k) plan, which, like a Health Savings Account withdrawal at age 65 or thereafter for a non-qualified expense, is included in taxable income. They can then preserve their Health Savings Account balances for future tax-free distributions (or pass tax-free to a spouse).

The concern among account owners that they’ll accumulate too much money in their accounts is overblown, except for those who are diagnosed with terminal illness shortly after age 65 or have a family history that makes a long post-65 life very unlikely. In the most quoted of projections of retiree medical costs, Fidelity® estimates that a couple retiring at age 65 in 2023 can expect to spend $315,000 in retirement for medical premiums and out-of-pocket expenses; dental and vision premiums and out-of-pocket expenses; and qualified over-the-counter drugs, medicine, equipment, and supplies. That figure increases by about $5,000 to $10,000 annually, which brings it to more than $742,000 if you’re retiring 30 years from now at 3% average annual medical inflation (and a frightening $982,000 if average medical inflation is just one point higher at 4%).

Few account owners can expect to accumulate a balance above that amount. For those who do, understand that, beginning at age 65, the tax treatment for a Health Savings Account distribution for a non-qualified expense and a tax-deferred 401(k) plan or Individual Retirement Arrangement distribution for any expense is identical. In both cases, the distribution is included in taxable income with no additional tax as a penalty.

Thus, it makes little sense to consciously stop accumulating balances in your Health Savings Account in the belief that the account is already sufficiently funded to cover qualified expenses in retirement. Those expenses are unknown, and some couples spend far more than $315,000. Distributions for non-qualified expenses aren’t taxed any less favorably than tax-deferred 401(k) plan withdrawals; you won’t lose spending power if your account is overfunded. So be sure to maximize contributions to your Health Savings Account as a means of achieving your goals for retirement savings.

 Resources

IRS Notice 2004-2:

 Q-25. How are distributions from an HSA taxed?

A-25. Distributions from an HSA used exclusively to pay for qualified medical expenses of the account beneficiary, his or her spouse, or dependents are excludable from gross income. In general, amounts in an HSA can be used for qualified medical expenses and will be excludable from gross income even if the individual is not currently eligible for contributions to the HSA.

However, any amount of the distribution not used exclusively to pay for qualified medical expenses of the account beneficiary, spouse or dependents is includable in gross income of the account beneficiary and is subject to an additional 10% tax on the amount includable, except in the case of distributions made after the account beneficiary's death, disability, or attaining age 65.

 [Author’s note: The 10% figure cited here increased to 20% effective Jan. 1, 2012, under a provision of the Affordable Care Act.]

 See Internal Revenue Code Section 223(f).

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The content of this column is informational only. It is not intended, nor should the reader construe the content, as legal advice. Please consult your personal legal, tax, or financial counsel for information about how this information applies to you or your entity.

HSA Question of the Week is published every week, alternating every other Wednesday with HSA Wednesday Wisdom and every other Monday with HSA Monday Mythbuster.