Category Archives: HSA Benefits

Using HSA Funds Once You Turn 65 Years Old

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Penalty on Non Qualified Withdrawals

Health Savings Accounts are generally required to be spent on qualified medical expenses. Contributions you make have great tax advantages based on the assumption that you will use them for their intended purpose, which is medical care for you and your family. Deviating from properly spending the funds can result in taxes due, as well as a 20% penalty. You can read about options for cashing out your HSA, but there aren’t many ways around getting money out without paying that 20% penalty.

That all changes once you reach the age of 65 years old. Besides being eligible for Medicare (which can affect your HSA eligibility), at age 65 your HSA no longer penalizes you for taking funds out of it. This is a huge advantage is your HSA becomes much more flexible and can be spent on anything, not just qualified medical expenses. This is one reason why HSA’s are a great retirement vehicle. While always avoiding tax on medical purchases, the HSA basically converts into a 401(k) or IRA (invest pre-tax, pay taxes later) at the time you turn 65. Conveniently, this is right around retirement time, so your HSA has served you like an IRA with a great medical option on it. As you will see, some distributions after age 65 will still incur a tax, but all distributions will avoid the 20% penalty. Per IRS Form 969:

Additional tax. There is an additional 20% tax on the part of your distributions not used for qualified medical expenses. However, there is no additional tax on distributions made after the date you are disabled, reach age 65, or die.

Using HSA funds for Qualified Medical Expenses at 65

Even after reaching 65, your Health Savings Account is still the best way to pay for medical, dental, or vision care for you and your family. This is because the triple-tax advantage still exists for the HSA: pre tax funds, no tax on earnings, and no tax for medical expenses. That means that any medical care you receive after age 65 is still paid for tax free using your HSA. You should remember this and guard those HSA dollars to avoid paying the tax man more than is needed.

For this reason alone, it may make sense not to use the HSA for things other than qualified medical expenses. As you will see, while you won’t be penalized on those “other” distributions, you will still be taxed, and in turn you forfeit the ability to spend those funds tax-free on medical care. Of course, even after age 65 you can still contribute to an HSA, but at that point you may not be on an HSA eligible plan or may have begun Medicare coverage, which prevents you from contributing. So once the genie is out of the bottle and the HSA funds are gone, it may be tough to get them back in and regain tax free medical spending. The point is to protect those HSA funds since they have the special ability to pay for medical care tax free, and we know that medical spending increases as we get older.

Using HSA funds for anything at 65

Above we mention the way to play this by the book, let’s talk about the fun way to use HSA funds. Once you turn 65, you can withdraw funds from your HSA without penalty. This means you can spend them on retirement, vacations, gifts for your family, fine wine and leather-bound books, or whatever you want. Any time before age 65 doing so would incur a steep 20% penalty on this “incorrect” usage of HSA funds, but in your golden years you can spend freely and enjoy the high life with your HSA. You no longer need to spend your HSA dollars only on qualified medical expenses.

After 65, HSA funds can be spent on things other than qualified medical expenses, but these amounts are added to income, which creates a tax liability.

The only downside is that you will still owe tax on these distributions from your HSA. Any funds you pull from your HSA for non qualified medical expenses will be added to income and taxed, but I argue this makes sense given the tax history of the contribution. You were able to contribute tax-free, your earnings grew tax free, and your funds need to be spent on medical expenses to continue to be tax free. Since you are not spending them on medical expenses, they are added to income like they should have been the year you made the contribution. However, at this point you have enjoyed the advantage of tax free investment growth compounded over many years.

In addition, delaying HSA distributions until this time is beneficial as your tax rate is likely lower in retirement. This results in less of a tax hit than it would have had you been taxed at the time of contribution, likely years ago. For example, at the peak of your career your marginal tax rate may have been 30%. But in retirement, you may be in a 15% tax bracket, so you have effectively arbitraged the tax system and saved yourself significant money.

Accounting for Distributions after 65 on Form 8889

Regardless of what you spend your HSA funds on, you will need to account for it each year with the IRS. This is done with HSA Form 8889 and specifically takes place in Part II – Distributions. We will examine two scenarios and how to account for them.

If you are 65 or older and use your HSA to purchase qualified medical expenses, your Form 8889 activity will look the same as if you were not 65. Specifically, you will call out the distribution, and classify it as being spent on qualified medical spending.

The following was prepared quickly using EasyForm8889.com

If you are 65 or older and you use you distribute from your HSA for something other than medical expenses, the treatment is a bit different. In this case, you call out the distribution amount but enter $0 for the amount spent on qualified medical expenses on Line 15. This will lead to taxable distribution on Line 16. However, there is a checkbox on 17a that you check for distributions over age 65, and line 17b backs these out from the 20% penalty.

This way, the amount is added back to taxable income but the penalty is avoided.

Note: if you need help accounting for your HSA distributions at age 65, please consider using my service EasyForm8889.com to complete Form 8889. It asks simple questions in a straightforward way and will generate your HSA tax forms in 10 minutes. It is fast and painless, no matter how complicated your HSA situation.

Can I Spend HSA Funds on My Spouse or Children?

Overview

One question that pops up fairly regularly is, “On whom can I spend my HSA funds?”. You have gone through all of the right steps of selecting HDHP coverage, opening an HSA, and making contributions to your HSA. You know that you need to spend you HSA dollars on qualified medical expenses, but whose medical expenses can be paid for with HSA dollars? In other words, we are defining what is a qualified medical expense, just the “who” part.

Luckily, there are three groups of people on whom can spend your Health Savings Account. In other words, these people receive benefits from your HSA, whether they are actually on your HSA insurance or not. Per IRS Publication 969:

Qualified medical expenses are those incurred by the following persons:

You and your spouse

All dependents you claim on your tax return

Any person you could have claimed as a dependent on your tax return (see exceptions)

So while your family may not be covered by your HSA eligible insurance, they are at least covered by your HSA dollars.

You and your Spouse

Intuitively, we know that you can spend your HSA funds on yourself. Heck, you insured yourself, opened the HSA, contributed the funds; I sure hope you can spend it on yourself!

What is less known is your HSA contributions can be used on your spouse as well. This is especially true if you have self-only coverage: even if not covered by an HDHP, medical expenses spent on your spouse are considered qualified. The benefit is your spouse can consume medical care on a pre-tax bases. One partner can save funds in their HSA, and still allow the other to use those dollars.

In fact, the plan owner need not be present during the spouse’s medical spending, nor does it have to be spent with your specific HSA funds or debit card. Like all qualified medical expenses, he/she can spend with regular cash or credit card, and later reimburse themselves with pre-tax HSA dollars. Of course, in this scenario you will want to save receipts in something like TrackHSA.com to justify the expense / reimbursement, but it just shows the flexibility that Health Savings Accounts offer spouses.

Children and other dependents

In addition to your spouse, you can spend your HSA dollars on your family. This generally includes your children or any other dependents you can claim on your tax return. The IRS defines dependents as a qualifying child or relative, based on the IRS guidelines. So this could include a family member relation for whom you care. This is a great incentive for people with kids as it allows many of their medical expenses to be purchased with pre-tax dollars, which saves money. Medical expenses for your dependents count as qualified medical expense, so go ahead and use your HSA for those purchases.

People you could have claimed as dependents

The IRS includes wording that includes an additional category of people who could have been your dependents, but were not for varying reasons. The goal of this third group is to increase the people for whom spending counts as your qualified medical expenses. The IRS defines this group as:

Any person you could have claimed as a dependent on your return except that:

The person filed a joint return,

The person had gross income of $4,050 or more, or

You, or your spouse if filing jointly, could be claimed as a dependent on someone else’s
return.

So these are not true dependents but are “candidates” for dependents but were not for various reasons. For example, if your children have a gross income above a certain threshold, they may not be considered a dependent, but the IRS allows their expenses to be qualified medical expenses for your HSA. In a similar vein, if you or your spouse can be claimed as dependents on someone else’s tax return (e.g. younger couples), the IRS waives this and allows the qualified medical expenses to occur.

HSA spending for children of divorced parents

IRS publication 969 provide specific language on how qualified medical expenses for children of divorced parents is handled:

For this purpose, a child of parents that are divorced, separated, or living apart for the last 6 months of the calendar year is treated as the dependent of both parents whether or not the custodial parent releases the claim to the child’s exemption.

Basically, they again increase the universe of people that constitute a qualified medical expense. They do this by saying, “if the parents were separated for the last year’s last 6 months, the child counts as a dependent for both for HSA’s”. In other words, either parent can use their HSA dollars for their children even if they are divorced/separated and dependent status is up in the air. The other parent’s actions regarding dependent and taxation do not affect how the other parent treats the child for qualified medical expenses on their Health Savings Account. This is a good ruling by the IRS as it allows more benefits to divorced families / children when it comes to their medical care.

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Note: if you need to keep track of HSA purchases for yourself, your spouse, or your children, please consider my service TrackHSA.com for your Health Savings Account record keeping. You can store purchases, upload receipts, and record reimbursements securely online.

Health Savings Accounts – the Pros and Cons

Overview

A frequent question those considering Health Savings Accounts often ask is, “What are the Pro’s and Con’s of HSA’s”? There are many different aspects of HSA’s that may benefit your particular situation, but there are some disadvantages as well. To clarify the issue, we have summarized the pro’s and con’s of Health Savings Accounts in a digestible format. Hopefully this information can help you decide if participation in HSA insurance is right for you.

The Pro’s of HSA’s

There are many reasons that Health Savings Accounts are beneficial and can help your family financially. Enrolling in HSA eligible insurance and opening a Health Savings Account can offer you the following benefits:

Lower Insurance Premiums

A core tenant of High Deductible Health Plans (HDHP’s) is a trade off of lower monthly premiums in exchange for a higher deductible. This reduces guaranteed costs (premiums) at the expense of occasional costs (deductible). This benefits healthy individuals and those that can pay for limited out of pocket care.

Lower Cost of Health Care

Part of the HSA’s triple tax advantage is that qualified medical expenses are paid on a tax free basis. The actual mechanism occurs first through tax free contributions to a Health Savings Account, then spending those dollars on qualified medical expenses. By not paying tax on healthcare, you reduce your cost by your marginal tax rate, which can be 15%, 25%, or 35%.

Lower Taxes

HSA’s are an effective vehicle to lower your income tax burden. For those in strong financial standing, they can allocate part of their income to an HSA instead of paying full taxes on it, creating a nest egg and lowering that year’s taxable income.

Keep the Money Forever

Unlike Flexible Spending Accounts (FSA’s) whose contributions expire at year end (the horror!), anything you contribute to your HSA remains yours for life. There is no need to operate under a “use it or lose it mentality”. This makes an HSA an investment since it becomes savings that you can spend as you see fit.

Get Started Quickly

Unlike other health plans and savings vehicles, you can open Health Savings Account very quickly. It does not require much paperwork or employer approval; all you really need are an HDHP and an account with a financial institution. Moreover, in the first year you can utilize the Last Month Rule to contribute the max amount, even if you only had partial year insurance.

Retirement Investment Vehicle

A major benefit of HSA’s occurs when the account holder turns 65, at which point HSA funds can be spent on anything without penalty. This differs than prior to age 65, when using HSA’s for non qualified medical expenses invokes both tax and penalty. Note that HSA funds spent on non qualified medical expenses will be taxed (like a 401(k)) but not penalized. However, the benefit is they would have grown tax free in your HSA. That means you can save diligently through your working years, spend what you need on medical, and use the rest to pad your retirement account.

Unemployment Safety Net

Health insurance premiums are generally not considered a qualified medical expense. However, if you are collecting government unemployment benefits, you are allowed to spend your HSA on health insurance premiums during that time. That means your HSA can function as your own unemployment insurance and help you through difficult times after losing a job.

Employer Contributions

If you are so lucky that your employer makes contributions to employee HSA’s, you may be able to receive some of that free money by signing up an HSA. This incentive can factor into your calculation when determining what type of insurance to buy.

The Con’s of HSA’s

Even though there are many positive aspects of HSA’s, there are some Con’s as well. Generally these involve the insurance itself and the IRS rules surrounding the account mechanics. Either way, it is important that you are aware of the following when making a decision about HSA’s.

Reduced Insurance Choices

Since not all insurance plans are HSA eligible, if you want an HSA you will be restricted to a subset of health insurance plans. These plans may or may not fit all of your health care needs, so be sure that your needs are being met by the insurance. In that regard HSA eligibility may be a “bonus” or a secondary factor in deciding which insurance to purchase.

Higher Deductible

The increased deductible required by HDHP’s is a reality that can cause financial hardship. It is not fun to have to spend $X,000 before your insurance kicks in, and the higher the number, the more you spend first. That is why if you have high medical costs an HDHP may not be the best fit for you.

Money tied up for Health Care

One downside of HSA contributions is that they are illiquid. Once they have been contributed, they are designated for medical expenses and nothing else. This can cause financial issues when you have a bunch of money in your HSA but have a non-medical need for the cash. There are a few ways to cash out an HSA but they often involve taxes and penalty.

Risk of Penalty and Fines

There are quite a few rules that govern the use of HSA’s, and some of them are very specific and (dare I say) onerous. By using an HSA you receive benefits but run the risk of putting yourself in a position to actually pay penalties if something goes wrong. The most common cause of fines is the Last Month Rule, so it is in your interest to familiarize yourself with it and other HSA rules.

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Note: if you have an HSA, please consider using my service EasyForm8889.com to complete Form 8889. It is fast and painless, no matter how complicated your HSA situation may be.