Sidney Kess

Health savings accounts (HSAs) are a consumer-driven alternative to traditional medical coverage that combine a high-deductible health plan (HDHP) with an IRA-like account called a health savings account (HSA). HSAs have been around for more than 15 years and continue to gain in popularity. According to the Employee Benefit Research Institute's EBRI HSA Database 2018 Report, which tracks and analyzes individual behavior in HSAs, enrollment was estimated to be as much as 33.7 million. About three of every 10 employees now have HSAs. Two-thirds of account holders ended the year with positive contribution amounts (contributions were greater than distributions for the year), with 95% of all accounts having money available at year end for the future.

Advantages of HSAs for Individuals

HSAs provide a triple tax benefit (Code §223): (1) contributions are tax deductible, (2) earnings on contributions are tax deferred, and (3) withdrawals to pay qualified medical expenses are tax free.

There are no income limits on eligibility to make and/or deduct contributions. Deductions by individuals are taken from gross income; no itemizing is required. The deduction is figured on Form 8889, Health Savings Accounts.

Under a “last month rule,” if an eligible individual is covered by an HDHP on Dec. 1, he or she is treated as eligible for the full year so that a full-year contribution is permitted; no proration is required. But there is recapture of the contribution unless the individual remains eligible through the end of the next year, meaning a full 2019 contribution is permitted and not recaptured as long as the individual remains eligible from Dec. 1, 2019, through Dec. 31, 2020.

The contribution limit is zero beginning in the first month that the taxpayer is enrolled in Medicare. For example, a taxpayer has an HDHP with self-only coverage and, when turning 65 July 2019, enrolls in Medicare. The contribution limit for 2019 for this person is $2,250 ([$3,500 + $1,000] x 6 ÷ 12).

Accounts can be tapped at any time for any reason by individuals without any oversight. In fact, some HSA custodians enable account holders to access funds via debit cards. For example, Fidelity offers its HSA account owners HSA debit cards, with additional cards available for spouses and dependents.

HSAs can be used as retirement savings vehicles. Contributions can be invested for growth (although the EBRI report referenced earlier found that only 4% were invested in assets; the rest were merely held in cash). There is no use-it-or-lost-it feature, so unused funds can accumulate and be available for retirement income. Distributions for non-medical purposes are taxed, but the usual 20% penalty ceases to apply at age 65.

Advantages of HSAs for Employers

Employers can use HSAs as part of their benefits offering in a variety of ways. They can pay for HDHPs and make contributions to employees' HSAs (these combined costs usually are lower than the cost of traditional health coverage). Or employers can merely allow employees to make their own HSA contributions, directly or through salary reduction arrangements under cafeteria plans. Contributions by employees through a salary reduction arrangement under a cafeteria plan are treated as employer contributions (i.e., they are not deductible by employees).

Employers that choose to contribute to employees' HSAs can deduct their contributions. What's more, the contributions are exempt from employment (FICA and FUTA) taxes.

The accounts are managed by employees, not employers or employers' administrators. It's up to employees to track whether distributions are being used for qualified medical expenses, which are tax free, or for other purposes, which are taxable.

Contributions by a partnership to a partner's HSA for services rendered are treated as guaranteed payments that are deductible by the partnership and includible in the partner's gross income. The partner can deduct the contribution made to the partner's HSA.

Similarly, contributions by an S corporation to an HSA of a more-than-2% shareholder-employee are deductible by the S corporation and includible in the shareholder-employee's gross income (reported on the shareholder's Form W-2). The shareholder-employee can deduct on his/her Form 1040 the contribution made to the shareholder-employee's HSA.

If an employer mistakenly makes HSA contributions to an employee's account, they can be recouped. Previously, the IRS explained that this can be done where, for example, no contribution should have been made because the employee was ineligible (Notice 2008-59, Q&A 23 and 24). More recently, the IRS added a number of other examples where the employer can ask the financial institution to return the mistaken contribution (IRS Letter 2018-033) (e.g., the amount withheld and deposited was greater than the amount on the employee's HSA salary reduction election). If the mistaken contribution is not returned by the end of the year, however, it must be treated as taxable compensation included on the employee's Form W-2.

HDHPs

A HDHP is a plan that has minimum insurance-imposed deductibles and cap on out-of-pocket costs (insurance deductibles, co-payments, and other amounts, but not most insurance premiums). The annual amounts are fixed by the IRS.

For 2019, the minimum deductible is $1,350 for self-only coverage and $2,700 for family coverage (Rev. Proc. 2018-30, IRB 2018-21, 662). The out-of-pocket limit is $6,750 for self-only coverage and $13,500 for family coverage. Out-of-pocket expenses include deductible, co-payments, and other amounts other than premium costs.

For 2020, the minimum deductible is $1,400 for self-only coverage and $2,800 for family coverage (Rev. Proc. 2019-25, IRB 2019-22, 1261). The out-of-pocket limit is $6,900 for self-only coverage and $13,800 for family coverage. Out-of-pocket expenses include deductible, co-payments, and other amounts other than premium costs.

Annual Contributions

Contributions must be made in cash and can be added to an HSA up to the due date of the tax return for the year to which the contributions relate. For example, in 2019, contributions can be made up to April 15, 2020. Obtaining a filing extension does not give a taxpayer any additional time to make contributions.

There is a dollar limit on the amount that can be contributed annually to HSAs. For 2019, the contribution limit is $3,500 for self-only coverage and $7,000 for family coverage. For 2020, the contribution limit is $3,350 for self-only coverage and $7,100 for family coverage. Those who are at least 55 years old by the end of the year can add another $1,000. If both spouses are this age, the couple can each add an additional $1,000, provided they use separate HSAs.

Legislative Proposals for HSAs

The Health Savings Account Expansion Act of 2019 (H.R. 603) would favorably modify HSAs in several ways. It would increase maximum contribution amounts substantially and cut in half the penalty for non-medical distributions. It would also allow tax-free distributions to pay health insurance premiums, direct primary care (DPCs), and non-prescribed over-the-counter medications. Finally, it would eliminate the need to be covered by an HDHP.

A similar measure (but not identical), the Health Savings Act of 2019 (S. 12), is also under consideration in Congress. It would allow both spouses to make catch-up contributions to the same HSA.

Conclusion

With health care costs still high, HSAs are one way to handle them on a tax-advantaged basis. More details about HSAs can be found in IRS Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans.

Sidney Kess, CPA-attorney, is of counsel at Kostelanetz & Fink and senior consultant to Citrin Cooperman & Company.