Tag Archives: Distributions

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.

How to Handle Excess Contributions on HSA Tax Form 8889

Overview

Excess Contributions occur when you contribute more to your HSA than you were allowed. This compares your contribution limit for the year (which can vary on many factors) and the actual amount of money that came into your HSA, including such things as Employer Contributions, Qualified Funding Distributions, and Prior Year Contributions. That being said, if you find yourself in a situation facing Excess Contributions, you may find it a challenge come tax time when you are faced with Form 8889. Fear not, as this article will guide you through how to avoid taxes and penalties and get this IRS required tax form filed.

Include the Excess Amount in Contributions

Part I of Form 8889 is appropriately called “Contributions”. It details amounts contributed to your HSA, your contribution limit, and calculates the deductible amount that flows over to Form 1040. It will feel strange, but you want to include all amounts contributed to your HSA, even if they are in excess. Doing so accurately reflects the account activity, so that when your HSA custodian provides Form 5498-SA to the IRS, the amount contributed will match your Form 8889. Remember, there is no taxes and penalty for having excess contributions in your HSA, if you remove them (and any earnings) before your tax filing deadline. The point is it is OK to show excess contributions in the contribution section of Form 8889, the key is that you have to proactively take care of them.

Example: Excess Contributions on Form 8889 Part I – Contributions

In this example we contributed $4,850 (contribution, employer contribution, and funding distribution) to our HSA. However, our contribution limit was only $3350, leading to an excess contribution of $1,500. The key is that we have included all contributions that caused the excess contributions and lived to tell the tale.

An example of 2016 Form 8889 prepared by EasyForm8889.com

HSA_excess_contribution_form_8889_1

Notice the warning at the bottom that states:

“Caution: If line 2 is more than line 13, you may have to pay an additional tax (see instructions).

Our Line 2 ($4,350) is indeed greater than Line 13 ($2,850), so we are at risk of paying excess tax. However, per the instructions, if we remove the excess contribution and any earnings on it before the tax deadline, we owe no taxes or penalty:

HSA_Excess_Contribution_instructions

To rectify this scenario, we would need to log into our Health Savings Account and request a distribution that specifically states it is a removal of an excess contribution for 2016 (see next section). You must specify this so that they don’t code it as a regular distribution for qualified medical expenses. In the above example this would be for $1,500 coming back out of the HSA. We will account for that removal in the next section.

Include the Excess Amount in Distributions

Part II of Form 8889 is called “Distributions” and details money that came out of your HSA. Similar to the logic stated in Part I, we need to be transparent about the excess contribution to avoid the ire of the IRS (and taxes and penalty). We will do this by 1) counting the removed excess contribution as a distribution and 2) calling it out as a distribution due to excess contribution. Again, you need to remove excess contributions (and any earnings) from your HSA before the tax filing deadline, and doing so creates a distribution from your HSA.

To actually remove the excess contribution, you need to go to the website of your HSA custodian and create a distribution for the excess contribution. When you do this (important), there should be a box stating “I am removing an excess contribution from my HSA”. This differentiates the distribution from one being used for qualified medical expenses, and informs your HSA custodian how to code the distribution on Form 1099-SA. If you correct the excess contribution before tax year end, this distribution will be reported on that year’s Form 1099-SA. If you do this in the following year (say, Jan-April 15th, before tax day), your HSA custodian may or may not send you a 1099-SA for the distribution before tax day. If they don’t, you need to keep that distribution of excess contributions in mind for filing taxes.

Example: Excess Contributions on Form 8889 Part II – Distributions

Reporting this activity on Form 8889 is relatively easy, as there is a mechanism in Line 14 that handles excess contributions for us. Back to our example of a $1,500 excess contribution that was removed, our Form 8889 ends up looking like this:

An example of 2016 Form 8889 prepared by EasyForm8889.com

HSA_excess_contribution_form_8889_2

Line 14 has 3 parts that we use to detail our distributions. We include the excess contributions removed in this total amount, and call out the amounts that were removed due to excess in 14b. The breakdown of line 14 is below:

Line 14a – The total amount of distributions for the year, including those for excess contributions and their earnings
Line 14b – Distributions that were for excess contributions and their earnings
Line 14c – A calculation of distributions that should have been spent on qualified medical expenses

As you can see, excess contributions avoid taxes here because they are excluded from Line 14c. If any amounts in 14c are not spent on qualified medical expenses, they are taxed and penalized. We stated that $300 that we normally distributed was spent on qualified medical expenses, by tracking our receipts in a tool like TrackHSA.com. The takeaway from the above logic is that the IRS does not expect you to spend excess contributions on QME, and does not tax or penalize you on these distributions if they are handled properly.

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Note: if you want step by step instructions for your Excess Contributions on Form 8899, or just want to get it right the first time, 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.

What is HSA Form 1099-SA?

Form 1099-SA Overview

Form 1099-SA is a form that your HSA custodian is required to file and send you each year you make distributions from your Health Savings Account. Its job is to quantify the monies that have left your HSA during the year, otherwise known as HSA distributions. There are many reasons that HSA distributions occur, including paying for qualified medical expenses, reimbursing yourself for previously paid qualified medical expenses, and cashing out your HSA. Your HSA custodian (bank) provides you this information in an official format so that the government knows the “official” figure when you go to file HSA tax Form 8889 for a given tax year. Form 1099-SA is a control to see money leaving the account, and Form 8889 verifies is was spent correctly.

An example of HSA Form 1099-SA for 2016
hsa-form-1099-sa-for-2016

Form 1099-SA Instructions

There are basically two parts of Form 1099-SA that you will see. The left hand side contains trustee (bank) and account holder information, while the right hand side includes multiple pieces of information about the distribution, its classification, amount, and tax treatment. This information is contained in Form 1099-SA boxes that we will cover here.

Box 1 Gross Distributions
This box represents the total amount of the distribution, but does not include earnings (see Box 2). Basically the total amount that came out of the HSA for a given distribution code (see Box 3). This section does not include withdrawal of excess employer contributions (and earnings) or excess MA MSA contributions, if this applies.
Box 2 Earnings on Excess Contributions
This box only applies if you have Excess Contributions to your HSA, and it shows the total earnings on excess contributions that were returned (distributed) before the tax return due date. It calls out these “special” (read: taxable) earnings that only occurred because excess contributions were sitting in your HSA.
Box 3 Distribution Codes
Form 1099-SA has a section in Box 3 that labels the type of distribution being reported. See the next section called “Box 3 Distribution Codes” to understand the codes found here.
Box 4 FMV on Date of Death
If the account holder has died, the fair market value of the account is entered on the date of death.
Box 5 Checkbox
This is a simple checkbox to indicate whether the distribution is from an HSA, Archer MSA, or MA MSA.

Box 3 Distribution Codes

Form 1099-SA has a coding scheme on Box 3 that describes the type of distribution being recorded on the form. There are six types of distribution codes that are described below. Note that you may receive multiple Form 1099-SA’s with different distribution codes. This is so they can clearly delineate different tax treatment of distributions and handle them separately.

Normal Distributions – normal distributions for the account holder (e.g. reimbursing previously paid expenses) or direct payments to a medical service provider. Used if no other code applies – basically if you take money out and don’t flag it as one of the other codes, they will code it this way.
Excess Contributions – if you are removing Excess Contributions from your HSA, it will be coded as a 2. For example, if your contribution limit for 2016 is $3,400 and you contribute $4,000, you can remove $600 before you file your tax return free of penalty. This $600 will be flagged as a 2 here.
Disability – this code flags distributions after the account holder became disabled. This involves alerting your HSA custodian that you have become disabled, and ties into line 17a on Form 8889.
Death Distribution (other than code 6) – this is used for payments to a decedent’s estate in the year of death. It also codes payments to an estate after the year of death. See the instructions for more details.
Prohibited Transaction – codes transactions per IRS sections 220(e)(2) and 223(e)(2). Basically transactions should not have occurred or are in error.
Death Distribution after year of death to nonspouse beneficiary – this is for payments to a nonspouse beneficiary, other than an estate, after the year of death. There are special HSA considerations for the year after an account holder dies. This code is basically a full taxable flag to remove the funds as non HSA (going forward).

HSA Form 1099-SA – Examples

The below images show what a completed Form 1099-SA might look like from your HSA custodian. You can expect to receive this in the first few months of the new year, before your taxes are due. Some HSA banks send the form electronically so keep an eye on your email or check your bank documents within your account.

Here is an example of the most common distribution code 1 – a normal distribution used to purchase a qualified medical expense:

hsa-form-1099-sa-completed-normal-distribution-2016

And here is an example of what an Excess Contribution might look like on Form 1099-SA:

hsa-form-1099-sa-completed-excess-contribution-for-2016

HSA Transfers avoided on Form 1099-SA

You will not see trustee to trustee transfers for your HSA. This also includes transfers from an MSA to an HSA, and vice versa. A trustee to trustee transfer occurs when your bank transfers HSA funds directly to another bank which also holds an HSA for you. You do not receive a check, and these amounts are not included as contributions or rollovers. Basically you are just transferring money between HSA accounts so nothing to report. See the difference between HSA Rollovers and Qualified HSA Funding Distributions.

Mistaken Distributions on Form 1099-SA

It may occur that you accidentally or mistakenly distribute from your HSA when you shouldn’t have. Most often money is transferred out of your HSA for a reasonable reason that turns out to be in error. Luckily, the IRS allows you to pay back an incorrect HSA distribution without penalty. You want to correct the situation that year as otherwise, you will incur penalties and taxes on the mistaken distribution. Per the IRS Instructions for Form 1099-SA:

If amounts were distributed during the year from an HSA because of a mistake of fact due to reasonable cause, the account beneficiary may repay the mistaken distribution no later than April 15 following the first year the account beneficiary knew or should have known the distribution was a mistake.

For example, if $1000 is mistakenly distributed from your HSA, and you had $0 spending on HSA’s this year, Line 16 of Form 8889 will show a positive $1000 which will be taxed and penalized. This is because without a qualified medical expense to offset it, the distribution is treated as a non qualified distribution. Instead, you can inform your HSA custodian before April 15th of the following year, and pay the distribution back. This might occur if you thought an expense was qualified but is not. In this case the withdrawal is not taxed or penalized, and paying it back is not treated as a contribution (or excess contribution) on Form 5498-SA.

Death of Account Beneficiary

There is quite a few different scenarios that can occur at the death of an HSA account beneficiary. Basically, if a spouse inherits the HSA, it continues being an HSA in their name. Otherwise, the HSA is liquidated and ceases to be an HSA. Much of this is outside the scope of this article but please the IRS Instructions (pdf) for Form 1099-SA for more information.

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Note: if you are struggling with HSA taxes, please consider using my service EasyForm8889.com to complete Form 8889. It is fast and painless, no matter how complicated your HSA situation.