Do You Have to Substantiate HSA Expenses? No . . . I Mean Yes.

It's more than mere semantics that either a "yes" or "no" answer to that question may be correct depending on your definition of substantiation. But it's not your definition that counts.

Health Savings Account distributions are tax-free when they reimburse qualified medical expenses. But who determines which expenses are qualified? And how does that process take place?

If you've ever enrolled in your company's Health FSA program, you understand the substantiation rules. You've probably received requests to verify debit-card purchases at your dentist or optometrist. And you know that you must submit proper documentation when you submit a manual claim to reimburse you for a qualified expense that you paid with personal funds.

Health Savings Account substantiation doesn't work as it does with Health FSAs. But it's important not to ignore the importance of having proper documentation to substantiate withdrawals from your account.

Third-party Substantiation

Participants in Health FSA programs understand the concept of third-party substantiation. Because reimbursements are limited to qualified expenses, the administrator must verify that balances pay for qualified items only. If you pay with a debit card, in most cases the administrator can use some simple tools (the industry terms for these tools are copay matching, IIAS, and 90% merchants) to substantiate most debit-card purchases. In other cases (common examples include medical deductible expenses and most services purchased from dentists and optometrists), you receive a request to provide a detailed receipt. If you file a manual claim, you must attach or upload a detailed receipt.

Health Savings Accounts have different substantiation rules from Health FSA for two important reasons.

First, you can withdraw funds for any expenses, qualified or non-qualified (though non-qualified distributions are included in taxable income and may be subject to a 20% additional tax as a penalty).

Second, under federal tax law, neither the account administrator nor your employer can require substantiation as a condition of accessing your balances. To quote from the first comprehensive Health Savings Account guidance (see Q&A 79 here) issued in 2004: "The HSA trust or custodial agreement may not contain a provision that restricts HSA distributions to pay or reimburse only the account beneficiary’s qualified medical expenses. Thus, the account beneficiary is entitled to distributions for any purpose and distributions may be used to pay or reimburse qualified medical expenses or for other nonmedical expenditures. Only the account beneficiary may determine how the HSA distributions will be used." 

A best practice in the market is for your Health Savings Account administrator to use behind-the-scenes coding on your debit card to limit transactions to either qualified expenses or locations most likely to sell qualified goods and services (the same coding applied to Health FSA cards). Administrators must offer another means of reimbursement - usually a direct request for a check or electronic transfer of funds from your Health Savings Account to a personal account - so that you can withdraw funds for any expense.

Thus, if you're answering the question about whether you must substantiate reimbursements from a Health Saving Account, you may respond "no" based on the absence of required third-party substantiation.

But . . .

Self-substantiation

The original Health Savings Account guidance, issued in 2004, had this to say about substantiation (see Q&A 25 here): "Individuals who establish HSAs make that determination and should maintain records of their medical expenses sufficient to show that the distributions have been made exclusively for qualified medical expenses and are therefore excludable from gross income."

In other words, Health Savings Account owners are responsible for substantiating their own expenses. What does this mean? Owners must

1. know which expenses are qualified (and thus distributions are tax-free) and which are not qualified (and thus withdrawals are included in taxable income and in many cases subject to an additional tax as a penalty).
2. report their activity when they file their personal income tax returns. They complete Form 8889 and sum their distributions for qualified and non-qualified expenses.
3. maintain adequate records to support their reporting of qualified expenses if their tax return is selected for audit.

This model closely follows the reporting of mortgage interest on a personal income tax return. You report your total interest paid when you itemize your deductions on Schedule A, Line 8, without including documentation with your tax return. You maintain records - a statement from the mortgagee - in your tax files to document the amount paid. And it's similar to a deduction for charitable contributions. You sum your total cash and non-cash contributions on Schedule A, Lines 11 and 12 without listing each donation (though your tax software may have you separately record each contribution, then populate Lines 11 and 12 with the totals).

Proper Documentation

Health Savings Account withdrawals are tax-free when they reimburse qualified medical expenses incurred by qualified family members with date of service on or after the date that you establish the account. A complete substantiation document thus must include the following information:

• Date of service
• Name of the patient
• Description of the service
• Name of the provider
• Dollar amount of patient responsibility

What constitutes a proper document? An explanation of benefits or monthly statement from your insurer contains these elements. So does a download from your online portal with the insurer. A detailed dental bill or an order for prescription glasses or contact lenses also contains this information. A detailed cash-register receipt for the purchase of over-the-counter drugs, medicine, equipment, and supplies typically includes all elements except that name of the patient (though it's reasonably assumed that the purchase if for a qualified family member). Quick tip: Be sure to print a copy or electronically store a cash-register receipt. The print typically disappears over time.

A debit-card receipt showing the amount of the purchase doesn't satisfy these requirements. Such a document doesn't show a description of the service or the name of the patient, so it's not possible to determine from that information whether the item or service purchased was a qualified medical expense.

Be sure to store your substantiation documents. For how long? The Internal Revenue Service has up to three years to require an audit of your personal income tax return. Thus, you must maintain records for at least three years after the end of the tax year that you make the withdrawal from your Health Savings Account. If you reimburse expenses immediately, you can discard receipts for qualified reimbursements in 2023 as early as 2027.

If you defer reimbursement of qualified expenses (for example, you want to retain your balance to grow tax-free to reimburse future qualified expenses), consider retaining your receipts forever. You face no deadline to reimburse qualified expenses tax-free, so you can reimburse those expenses tax-free at any time.

Example: You pay your qualified expenses with personal (after-tax) funds to preserve your Health Savings Account balance to grow tax-free to cover your retirement expenses. At age 58, you suddenly need $12,000 cash. Your only savings are a qualified retirement account (a penalty for premature withdrawal, plus income taxes applied) and your Health Savings Account. You can withdraw $12,000 from your Health Savings Account, pair that distribution with $12,000 of qualified expenses that you didn't reimburse previously, and record the transaction as a withdrawal for qualified expenses on that year's tax return.

If you want to maintain this level of flexibility to address an unexpected life event, be sure to maintain documentation indefinitely.

The Bottom Line

The proper answer to the question is, "Yes, distributions from a Health Savings Account must be substantiated." That substantiation can't be required by the administrator or the employer (when the Health Savings Account program is employer-based, as is typical). But substantiation is required, nonetheless. If your tax return is selected for audit and you don't have the proper documentation, you could face additional taxes, interest, and penalties.

#HSAMondayMythbuster #HSAWednesdayWisdom #HSA #TaxPerfect #HealthSavingsAccount Coming soon: #ICHRAinsights

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.