Automatic vs Manual HSA Contributions

This question was submitted by HSA reader Adam. Send yours in to evan@hsaedge.com

You explain that contributing to your HSA via automatic payroll contributions is “preferred”, yet you then explain how you choose to contribute manually every month. Is there an advantage to doing it that way?

Either method of contribution will get you to the same place, but there are a few advantages to either. Automatic payroll HSA contributions are defined as deductions from your paycheck each pay period, so you see the contribution amount taken out before taxes are paid on each check. First, if you have automatic payroll contributions, your employer is onboard with the HSA program so there may be the opportunity for employer HSA contributions which would be free money. More generally, contributions made through payroll are “pre-tax” so you immediately recognize tax savings each month (e.g. my taxable income is lower each month, less taxes paid). It also creates a disciplined system where you avoid “forgetting” to contribute, and your contributions are accounted for and organized each month and at year end. Overall it is a more organized, disciplined approach.

My employer never supported HSA contributions so I made manual contributions. To do this, I set an automatic monthly transfer from my bank account to my HSA after my second paycheck. I timed it such in case I needed to cancel the contribution, but doing it after your first pay check is probably more disciplined. These were post-tax dollars being contributed, so I paid taxes upfront and was refunded those taxes once I filed taxes. This creates money “on loan” to the government, but it was nice to get a refund. My HSA provider tracked my contributions for the year, so come tax time I verified this number, plugged it into my filing, and it helped decrease my tax liability for the year. Additionally, manual contributions gives you more flexibility to manage your cash flow. If you are investing your HSA (and know you will maintain coverage for the full year), you could max out your HSA contribution on January 1st, giving your money an extra year to grow. Or you could break it up into quarterly contributions, or contribute at year end with any money leftover.

Either way, after filing taxes your tax liability will be the same, manual contributions just involves paying the government money and then asking for it back.

HSA Contribution Limits If Your Health Insurance Changes Mid Year

This post is based on a great question that came from an HSA Edge reader. Feel free to email any questions you may have to evan@HSAedge.com

We all know that our Health Savings Account has a contribution limit (2014 = $3,300 / $6,550), a maximum amount of tax free contribution that cannot be exceeded during the year. This is all fine and dandy assuming you start the year with an HSA plan and end the year with the same HSA plan. But what if your health insurance changes mid year? How does this affect your HSA? It turns out, changing your health insurance during a fiscal year can have an impact on how much you can contribute. If not followed properly, this can lead you to over contribute, causing painful penalties or taxes.

Below are 3 scenarios that show how changing your health insurance affects your contributions:

1) Sign up for HSA eligible insurance during the year

If you sign up for an HSA eligible health insurance plan during the year, you are on the right track to open a health savings account and begin contributing. You are allowed to make full contributions for a year if you are covered by HSA eligible health insurance on December 1st of that year. This is explained in detail in the post on the Last Month Rule. The summary is that when you start a new HSA eligible health insurance plan, you can contribute up to the maximum contribution limit during the first year if you had coverage on the first day of the last month of the year. In other words, if you have a plan opened by December 1st, you can contribute up to the max.

However, this is enforced by the Testing Period, which says that if you are going to take advantage in that first year and contribute more than your pro-rata share, you have to stay on an HSA eligible plan for a corresponding time during that subsequent year. If not, you have in fact over contributed and penalties / taxes occur. Thus, if you are going to sneak in a full year contribution during your first year on an HSA plan, make sure you are not just a flash in the pan and are planning on staying on that plan for a while.

2) Switch health insurance plans to other HSA eligible plan mid year

This is quite simple: if you change health insurance plans, and both are HSA eligible, there is no effect to your contribution amount for the year. In the IRS’s eyes, you are covered by an HSA eligible plan for the full year, so you are able to make full contributions. The example here is you have an HSA eligible plan Jan > May, but in June you hop on an employer sponsored plan that is also HSA elibile. No problem, go ahead and make full contributions.

However, remember that the test for HSA eligibility occurs on the first of the month. This means that on the first day of each month, if you have HSA insurance and are an eligible individual, you “earn” 1/12th of the maximum contribution limit for that month. It follows that if you have coverage in each month, you earn 12/12 or 100% of the maximum contribution limit for the year. On the other hand, if you make a switch that is not in effect on the first of the month, you will lose that 1/12th of the contribution limit. The effect is your contribution limit is reduced and only equal to those months you have coverage.

The alternative scenario is covered by the final section…

3) Leave a HSA eligible plan mid year

Same scenario, covered by HSA eligible plan Jan > May, but you switch to a health insurance plan that is not HSA eligible in the middle of the year. What then?

This is where things get tricky. While the IRS is not super clear on this, the interpretation is that you are only allowed to contribute to an HSA for the months of a year you remain on the insurance plan. Basically, contribution limits are pro-rata based on the amount of time you are on the plan. If you are single ($3,300 2014 max) on the plan for 6 months, your maximum contribution limit is (6/12 * $3300) = $1,650. If you on the plan for 10 months, your maximum contribution = (10/12 * $3300) = $2,750. You are effectively capped out when you quit the plan to avoid taking advantage of the tax break.

That raises the real risk of penalties and taxes resulting from over-contributing. Consider the following scenario:

Strong earner
Maxes out HSA contribution early in year
Due to unforeseen circumstances, no longer HSA eligible sometime mid year

This presents a real problem for that person as they have in effect over contributed for the year. Even if they were able to reimburse their full contribution against qualified medical expenses, they have deducted too much from their income and will result with over contribution penalties and taxes, which are evil. The advice is you may want to space out your yearly HSA contributions by month / quarter as to avoid the risk of over contribution. This does not mean you cannot reimburse for prior medical expenses. In this scenario, you could incur $3,300 in qualified medical expenses in January and contribute monthly, reimbursing yourself for that $3,300 over time. However, this strategy puts a circuit breaker in the equation should you change health insurance to a non HSA eligible plan mid year, preventing you from penalties and taxes.

Note: to regardless of your coverage, to track your HSA spending please consider my service TrackHSA.com for your Health Savings Account record keeping. You can store purchases, upload receipts, and record reimbursements securely online.

Can You Cash Out an HSA?

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After saving diligently, using either individual or employer contributions, you may want to take your money out of your Health Savings Account and use it for something different. Before you go to the ATM or HSA website and withdraw all of your HSA funds, take heed: there may be tax consequences to improperly withdrawing money. Let’s discuss the implications and options.

Part of the advantage of an HSA is that the money is triple tax advantaged – you are able to save significantly on taxes by contributing to the HSA. The catch is, this money is required to be used for qualified medical expenses. As such, the government does not look fondly at taking a tax advantage and then not playing by the rules.

Nevertheless, let’s discuss 4 options for removing money from an HSA account:

1) Non Qualified Withdrawal (Penalty Tax)

This is the hard way, just rip the money out and pay the price. From the IRS HSA page:

You can receive tax-free distributions from your HSA to pay or be reimbursed for qualified medical expenses you incur after you establish the HSA. If you receive distributions for other reasons, the amount you withdraw will be subject to income tax and may be subject to an additional 20% tax.

Yes, that 20% tax sure bites, as it was your money to begin with but it is stuck in a “special” government account. That said, this is always an option. When you file your IRS Form 8899, you will have to call out this amount on Line 16 as a taxable distribution. This amount will be added as income on Form 1040 (i.e. you will then pay tax on it), plus Line 17b will assess a 20% penalty that flows over to Form 1040. An expensive option, but at least you can get the funds out of the HSA.

2) Use for Qualified Medical Expenses

This is the right way to remove funds from an HSA account, paying for (or reimbursing) qualified medical expenses. Assume you have a doctor appointment that you pay for out of pocket using a credit card, debit card, or cash. Since this is a qualified medical expense, you are immediately entitled to reimburse yourself for that expense out of your HSA. This is simply a transfer from HSA to other account for the amount of the expense, justified by the receipt. Little by little, you can gradually drain your HSA as you use it to pay for qualified medical expenses. Or, you may want to pull an expense (say, surgery or dental expense) forward so at least you can use those HSA funds. Remember, you can spend HSA funds on other people than just yourself.

Alternatively, you can preempt this situation by building up a nice stack of pending reimbursements. This would involved paying for medical expenses out of pocket and delaying your reimbursement from the HSA. You are then entitled to that reimbursement at any time. Eventually, these reimbursements can add up and you can withdraw a large sum from your HSA. My service TrackHSA.com is a great way to keep a record of these un-reimbursed transactions.

3) Invest your HSA, offset by separate account withdrawal

We know that you can invest your HSA account in stocks, bonds, ETF’s, etc. to let it grow over time. If you need cash, consider other sources first. Instead of raiding your HSA, consider withdrawing funds from a different investment account with no / less penalty. Then, you can invest your HSA to “replace” your prior withdrawal.

For example, assume that I need $2k for some reason. Instead of withdrawing from my HSA and facing a penalty, I could withdraw this from a more liquid account, such as an investment account. I could then offset this by investing my HSA in the same instruments that I just sold, so my investment position is maintained. This could also work if the other account (such as a 401(k)) has a withdrawal penalty but it is smaller (say, 10%) than that of the HSA (20%).

4) Use the funds for anything once you turn 65

Once you turn 65 years of age, your Health Savings Account is liberated substantially. You are free to spend your HSA funds on whatever you want, not just qualified medical expenses. Note that any distribution for non qualified medical expenses will be taxed (just like ordinary income), but at least you are getting the funds out of your HSA. This is fair as well because you never paid tax on the HSA contribution – since you didn’t use it for medical expenses, they make you pay it now. However, you may have gotten the benefit of tax free investment earnings on that money for many years. Either way, this is superior to option 1 above as you do not owe the 20% penalty, just the tax. And that 20% can be a huge number

Note: if you have an HSA, you need to file IRS tax Form 8889 each year you make contributions or withdrawals. Please consider using my automated service EasyForm8889.com to quickly and easily generate your HSA Form 8889. In 10 minutes, it asks you simple questions that correctly populates Form 8889 no matter your situation and delivers you the completed PDF.