Tag Archives: Distributions

Spending HSA Funds on Step Children

Overview

You have HSA eligible coverage and opened a Health Savings Account, diligently making contributions throughout the year. You now have a nice nest egg to protect yourself from routine care, medical surprises, and emergencies. However, on whom you can spend your HSA funds can be confusing. We have previously discussed who can use your HSA funds but the issue of step children, or children of separated parents, is a special case. Sometimes, taxes and step children can be a tricky situation. In this article, we will discuss that step children can be the beneficiaries of your HSA funds.

The IRS Chimes In

The IRS generally lists 4 categories of people on whom you can spend your HSA contributions:

  1. You
  2. Your spouse
  3. Your dependents
  4. Anyone you could claim as a dependent

You will notice that step children are not mentioned in the common recipients here. But if you dig a little deeper into the IRS materials you will find a surprising answer. In a rare moment of foresight, the IRS directly addresses the case of step children issue in a follow up discussion of this rule. This appears in Form 969:

HSA-spend-on-spouse-children-step-children

The IRS states that if the parents have been divorced or separated or living apart for the last 6 months of the calendar year, the child is considered a dependent for both parents. That child then falls into point 3 in the above list of HSA eligible expenses, so you can spend your HSA on them.

A child of parents that are divorced, separated, or living apart for the past 6 months of the calendar year is treated as the dependent of both parents.

However, it isn’t clear if this “6 months” applies only to the 3rd case (living apart) or all three cases (divorced and separated). All hail the Oxford comma! Why the IRS includes this confusing 6 months of calendar year test is beyond me, perhaps it is used as some basis to confirm the parents are actually living apart for good. So what if the parents separated in January-June versus later in the year, say September? Does the 6 months of a calendar year (July-December) have to be satisfied before the child is treated as a dependent? That just seems weird to me.

HSA’s and Step Children

My interpretation (which has not been confirmed) is that the 6 months applies only to parents living apart. Thus, if you are divorced or separated, your HSA funds can be applied to your step children, regardless of who has custody of the children. Also note that this applies to your spouse’s children i.e. your stepchildren.

Let’s assume a situation where a mother and father with 1 child separate and remarry; here are some examples of who can spend HSA funds:

  • Mother spends HSA on child
  • Stepfather spends HSA on child (technically their stepchild)
  • Father spends HSA on child
  • Stepmother spends HSA on child (technically their stepchild)

In addition, if the mother and father remarry and their respective spouse has children, they now have stepchildren of their own and can spend their HSA on them:

  • Mother spends HSA on their stepchild
  • Father spends HSA on their stepchild

In sum, the HSA is flexible enough to allow for spending funds on stepchildren, if you can make your way past the IRS wording.

Note: If you need help preparing your HSA tax form 8889, please consider my service EasyForm8889.com. It asks you simple questions and fills out Form 8889 correctly for you in about 10 minutes.


EasyForm8889.com - complete HSA Form 8889 in 10 minutes!

Remove Amount Greater than Excess Contribution from HSA

This question was sent in by HSA Edge reader Dale. Feel free to send in your own question.

I was only eligible for an HSA in 2018 for July and switched health plans immediately after my contribution. I contributed $685 which is more than 1/12 of my allowable amount ($371). If I request an Excess Contribution Reversal for the entire $685 + interest, am I allowed to consider my entire $685 as Other Income and just pay income tax on it?

Making and Removing Excess Contributions

Each year, the IRS determines the contribution limit, or maximum amount, one is allowed to contribute to the HSA. However, note that your contribution limit may differ from the IRS limit. Reasons that this may differ are:

Anything above your personally calculated contribution limit is considered an excess contribution. Excess contributions are not good – in effect, you have exceeded the tax deduction afforded you by the IRS. The IRS likes to collect what is due to them, so, understandably, frowns on this.

You can remove excess contributions from your account in the tax year they occur without penalty.

Luckily, there are options to correct Excess Contributions after they occur. This involves removing your excess contribution from your HSA before the tax date of a given year. For most people, this is mid April, though extensions do apply. If excess contributions are not removed, a 6% penalty is due each year for as long as the excess contributions remain in the account. This can add up over time.

You are correct that you can remove the excess contribution for 2018 up until your tax filing deadline (with extension). Per Form 969:

HSA-excess-contribution-removal-IRS-rules

Removing non-Excess Contributions

However, one very important point is that you cannot just remove funds willy nilly from you HSA. In your above example, you contributed $685 compared to your contribution limit of $371. This means you have a $314 excess contribution that can be removed. The whole $685 cannot be removed without penalty.

Any funds removed from your account that are not excess contributions face penalty and tax.

The IRS is firm on the fact that once funds go into the HSA account, they are to be used for medical purposes. Besides excess contribution correction, any removal of funds from the account are considered “Non Qualified Deductions”. Per IRS 696:

HSA-non-qualified-distribution-tax-and-penalty

Note that the above text “not used for qualified medical expenses” is incredibly broad. It includes any sort of scenario, other than removing excess contributions, where HSA funds are coming out of your HSA and not being spent on qualified medical expenses. This comes up often from readers as they assume they have flexibility to contribute / distribute from the HSA as they see fit. The IRS does not agree, and once the money goes in, it is not easy to just take out. Thus, care and planning should occur for calculating how much to contribute to your HSA during a year.

Calculating Non Qualified Distribution Penalty

Removing funds from the HSA not spent on medical expenses is costly. If this applies to you, see our article “Can You Cash Out An HSA?” for options on getting the money out.

If the penalty is indeed due, you will need to pay both tax and penalty on the amount. This sort of makes sense – the IRS is 1) undoing the tax benefit you got from the initial contribution and 2) penalizing you for not following the rules. This assessment occurs in Part 2 of Form 8889 under “HSA Distributions”. Here is what that section looks like:

Form-8889-HSA-Distribution-Penalties-and-tax

As you can see above, assume you have a non qualified or “excess” distribution that came out of your HSA. #1 indicates where your non qualified distribution is added to income and is taxed. #2 indicates where the 20% penalty is calculated and added to your tax bill due.

Overall, it is an expensive way of getting your money out. Plan accordingly.

Note: If you want help calculating your distribution penalties and preparing your HSA tax forms, please consider my service EasyForm8889.com. It asks you simple questions and fills out Form 8889 correctly for you in about 10 minutes.


EasyForm8889.com - complete HSA Form 8889 in 10 minutes!

Delaying Reimbursement for HSA Purchases

This question was submitted by HSA Edge reader Phillip. Feel free to send in your question today to evan@hsaedge.com.

Does a $45 unreimbursed qualified medical expense (QME) equal only a $45 tax free withdraw later, or does it equal a ($45 + interest/gains) tax free withdraw later? Do you see the distinction?

Paying for Medical Expenses

Each year, you are allowed to make contributions to your HSA based on your coverage and age. Funds in your HSA can be distributed tax free for qualified medical expenses. Regardless of how the funds get in the account, they can come out tax free if used correctly.

That said, you face a choice each time you make a purchase for a qualified medical expense. You can either:

  1. Pay for the expense using funds from your HSA
  2. Pay for the expense using non-HSA funds (say, cash or your credit card)

If you use option 1, the transaction occurs quickly: you buy your medical item and your HSA is reduced.

If you elect option 2, the transaction can occur quite slowly: you buy your medical item with non-HSA funds, and you are now allowed to reimburse that purchase from your HSA at any time in the future. Reimburse means you can transfer funds from your HSA to another (bank) account you own to “pay back” the expense. Doing so in effect pays for the expense with tax-free funds from your HSA. See more information in the article “Using your HSA as an ATM“.

Delaying Reimbursement of Medical Expenses

The interesting thing is the timing of this distribution. If you do it immediately, the transaction ends up looking a lot like #1 above: the money flows from your HSA to your account, and the transaction is fully paid and reimbursed and completed. However, delaying this reimbursement provides some interesting options:

  • The amount of the purchase remains in your HSA
  • It can earn interest
  • It can be invested in stocks, ETFs, or bonds
  • It may grow to more than the initial amount of the purchase

The crux of your question is with the last bullet above – the purchase may grow to more than the initial amount. Perhaps substantially so. How do I handle this increased amount in my HSA?

Investment Gains in your HSA

In your example, you made a $45 purchase paid with cash instead of using HSA funds. You can reimburse (transfer) that $45 from the HSA to your bank account tax-free at any time, but not more than $45 since the receipt does not justify a higher amount. Going further, say you invested that $45 and it earned $100 before you reimburse (transfer) out the $45. You now have $100 sitting in your HSA. You cannot reimburse it against the $45 receipt, but you can use it to pay for future medical expenses.

Earnings in your HSA are handled just like any other HSA contribution.

When a new medical purchase occurs, this “new” $100 in your account provides two options:

  1. Distribute it to pay for the purchase
  2. Again pay using other funds and continue to invest the $100

Using #2 above, you can see how the whole cycle can repeat and grow your HSA.

This is a powerful concept because doing so allows you to grow medical (and later, retirement) funds tax free and distribute them at no (or low) cost. In theory, you can invest your HSA and grow it beyond the contribution limit for a given year.

Note: I created TrackHSA.com to track medical expenses you plan to later reimburse from your Health Savings Account. It provides record keeping to store purchases, upload receipts, and record reimbursements securely online, no matter how far in the future you choose to reimburse them.

TrackHSA logo