Qualified Expenses: Health FSA versus Health Savings Account

The lists are similar. But not identical. Be sure you know which and whose expenses you can reimburse tax-free from your Health Savings Account.

Both Health Savings Accounts and Health FSAs offer tax savings on contributions and distributions, allowing owners and participants to reimburse qualified expenses with tax-free funds. But what is a qualified expense?

The answer is important. Withdrawals from Health FSAs are limited to qualified expenses. The account administrator must verify that each transaction is qualified. In contrast, Health Savings Account owners self-substantiate their withdrawals as qualified. They have the flexibility to distribute funds for non-qualified expenses, though those withdrawals must be included in taxable income and are generally subject to additional taxes as a penalty.

What do you need to know to remain compliant with federal tax law if you own a Health Savings Account? Let's look at the law and contrast Health Savings Account withdrawals with the often-better-known Health FSA.

Section 213(d)

If you've ever owned a Health Savings Account or participated in a Health FSA, you've probably heard the term Section 213(d) expense. That's the industry reference to a service or an item that's qualified for the federal income tax medical deduction. It's also the framework for determining whether an item is qualified for the tax-free reimbursement from a Health Savings Account, a Health FSA, or a Health Reimbursement Arrangement (though employers, who sponsor HRAs, usually narrow considerably the range of qualified expenses).

When you dust off your pocket copy of the Internal Revenue Code, you won't see a neat little alphabetical list of qualified expenses like the one that your administrator provides. Instead, in Section 213, subsection D, you'll find this language:

(d) Definitions

For purposes of this section—

(1) The term “medical care” means amounts paid—

(A) for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body . . .

In other words, if it diagnoses, cures, mitigates, treats, or prevents an injury, illness, or condition, it's a qualified expense. That statement sounds straightforward, although there are some gray areas that Health FSA and HRA participants realize when the expense that they think is qualified isn't because they're using the item for general health rather than to address a medical condition. Examples of these gray-area items include vitamins and health-club memberships, both of which are not qualified when used for general health, but may be qualified when prescribed by a physician for a specific medical condition, such as prenatal vitamins or for malabsorption due to illness or surgery) and gym memberships to restore a bodily function following an injury or illness.

The same gray areas exist for Health Savings Account owners as well. The difference is that their administrator can't request documentation to substantiate that an expense is qualified. The account owner must report on her personal income tax return the sum of her annual withdrawals for both qualified and non-qualified expenses, then hope that an auditor agrees if her tax return is audited and her Health Savings Account activity scrutinized.

The Overlap

Any expense that's qualified for reimbursement through a Health FSA is also qualified for tax-free withdrawal from a Health Savings Account. This list almost always includes:

• your financial responsibility for all services covered by your medical plan. Insurers typically exclude coverage for services that fall outside the Section 213(d) definition.
• your financial responsibility for all services covered by your dental or vision plan. Same reason as medical.
• some services not covered by those plans. Insurers don't cover all qualified services. For example, your medical plan may not cover acupuncture or foot orthotics, your dental plan adult orthodontia, or your medical or vision plan vision-correction surgery. These services all diagnose, cure, mitigate, treat, or prevent an injury, illness, or condition, so they're qualified for tax-free reimbursement. Yes, even vision-correction surgery if your sole motive is vanity (not wanting to wear glasses any more to see at distance).
• services exceeding plan limits. Your medical plan may limit physical therapy to 30 visits annually, but you and your therapist believe that you're continuing to make progress after you reach that limit. Your dental plan may cap your annual benefit at $1,500, even if that amount doesn't cover an additional crown. In these cases, your out-of-pocket responsibility is a qualified expense because the service itself is qualified, even if it's beyond your plan's annual limit.
• many over-the-counter remedies, ranging from pain relievers and allergy medicine to bandages and C-PAP machine supplies.

And Health Savings Accounts Also Cover . . .

In addition to these services and items, you can reimburse certain premiums from your Health Savings Account (but not a Health FSA). The list:

• Medical premiums if you're collecting unemployment benefits or continuing coverage on your group plan by exercising your COBRA rights.
• Medicare premiums, including Part B (outpatient services), Part D (prescription-drug coverage), Part C (Medicare Advantage), and, if you didn't prepay your lifetime premium through payroll taxes during your working years, Part A (inpatient, home-health, and hospice care). But note that premiums for a Medicare Supplement plan (which pays some of your out-of-pocket costs when you're enrolled in Part A and Part B) are not qualified for tax-free reimbursement.
• Long-term care insurance premiums, but only if the plan meets certain requirements in the federal tax code, and is subject to annual limits based on your age. (For more information, see Page 11 here.)

Whose Expenses

Health FSAs and Health Savings Accounts follow different rules on which family members' qualified expenses can be reimbursed tax-free.

Health Savings Account. You can reimburse your own, your spouses, and your tax dependents' qualified expenses tax-free. If you withdraw funds for any other person's expenses, even for qualified services and items, the distribution isn't qualified. For more information about who qualifies as a tax dependent, see here.

Health FSA. You can reimburse your own, your spouse's, your tax dependents', and your children's (to age 26). A Health FSA follows many of the same tax rules as a medical plan. Under federal law, you can continue to cover a child on your medical child, even when the child no longer qualifies as your tax dependent, to age 26. This is a situation in which the Health FSA is more inclusive than the Health Savings Account.

Note that neither description above listed coverage as a defining factor. That's because it's not relevant. Whose expenses are qualified for tax-free reimbursement from each account is determined independent of each family member's medical coverage. Here are some important implications:

• You can reimburse tax-free expenses incurred by qualified family members who are not covered on your medical plan. For example, you and your spouse each carry self-only coverage through your respective companies (or she's enrolled in Medicare rather than an employer-sponsored plan). Your plan is HSA-qualified and hers isn't. You can still reimburse her expenses tax-free from your Health Savings Account because she's your spouse.
• You can not reimburse tax-free qualified expenses incurred by family members on your medical plan who don't meet the definition. For example, you can't reimburse tax-free your domestic partner's or ex-spouse's qualified expenses through either a Health Savings Account or a Health FSA. Also, if you cover an adult child who's no longer your tax dependent, you can not reimburse her expenses tax-free from your Health Savings Account (but you can through your Health FSA).

The Bottom Line

It's important to understand the rules to ensure that you're optimizing the benefits of your Health Savings Account (limiting reimbursements to qualified expenses to avoid taxes and penalties) and reporting your activity correctly to avoid getting into hot water with the Internal Revenue Service. It's common to trip up around coverage (assuming that you can reimburse tax-free expenses incurred by all family members covered by your medical plan) or believing that reimbursement is limited to medical-plan cost-sharing. Grasp these important concepts to get the most out of your account.

#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.