With tax season upon us, many people are looking for ways to decrease their taxes owed. If you have a qualifying High Deductible Health Plan (HDHP), you can use an HSA to reduce your tax liability for the year.
Tax Free Contributions
One of the main tax benefits of HSA’s is that money you contribute is tax exempt. You lower your taxable income by the amount of your HSA contribution. Thus, Health Savings Accounts can allow the total amount you in taxes in a given year.
The mechanics of this can work in two ways:
Automatic HSA Contributions (paycheck) – If your HSA contributions occur via your employer, when your paycheck is processed your HSA allocation will be pre-tax. It is removed form your income, and you pay taxes on the remaining income.
Thus, your taxable income = [Salary – HSA Contribution].
Manual Contributions – If you contribute to your HSA manually (say, by bank transfer each month), you will have earned the income and already paid taxes on it. Never fear, you will make this up in your tax filing. When you file your taxes (using Form 8889), you will declare how much you contributed to your HSA that year. This will be deducted from your Taxable Income, so you will receive those original payroll taxes back as a refund.
Again, your taxable income = [Salary – HSA Contirbution].
An Example of HSA Tax Savings
The maximum HSA contribution for 2014 is $3,300. Without an HSA, this $3,300 is earned and taxed as normal income. For example, if your tax rate is 25%, you pay $825 in taxes while the remaining $2,475 goes to your bank account. Federal and State taxes take a sizable amount of your earnings, and you keep 75%.
Using an HSA, you can divert this same $3,300 to a tax advantaged account so that you keep 100% of it. Instead of having money taxed and only $2,475 in your account, you have the whole $3,300. This is a tax savings of $825, or:
Tax Savings = HSA Contribution x Tax Rate
The best part is you own this money and get to keep it forever, unlike some flexible spending accounts. You can use your HSA to pay for many qualified medical expenses tax free. You can invest it and let it grow, and even use it for retirement without penalty (in this scenario, you would defer income taxes until retirement, likely paying taxes at a lower rate than currently). As you can see, you avoid (or defer) paying taxes, which keeps more money in your pocket to save and grow.
Update: I have finished and launched EasyForm8889.com, an online service to quickly and easily complete tax Form 8889 for your HSA. No matter your situation, it asks you simple questions and generates your completed Form 8889 PDF in less than 10 minutes. Try it today.
Two confusing concepts for Health Savings Accounts are the Last Month Rule and the Testing Period. Both of these help determine your contribution limit to your HSA during the year you first sign up for health insurance as an eligible individual. (Note: If you are filing HSA tax Form 8889 and are on Line 18 that says “Last Month Rule”, this only needs to be filled out if you failed the testing period and owe a penalty; read on. Otherwise, it is $0
I have created the following video to explain the Last Month Rule and Testing Period. Check it out, otherwise, the transcription of the information is below.
The Last Month Rule states that if you are covered by an HSA eligible health plan on the first day of the last month of a given year, you are considered an eligible individual for the entire year. This gives you the option to contribute the entire year’s contribution limit to your HSA, which is more than you would be allowed otherwise (pro rata by month).
If you are covered by an HSA eligible health plan on 12/1 of a given year, you can contribute (and deduct) the full year’s contribution limit.
For example, you could begin HSA coverage in November of a given year. Come December 1st, you are covered and per the Last Month Rule, are considered an eligible employee for that full year. That allows you to contribute up to that year’s contribution limit, if you want, even waiting a few months to make a prior year contribution. Back up the truck and load up the HSA!
However, the Last Month Rule is a powerful tool that does bear risk and further responsibility.
The Testing Period
The Testing Period states that if you use the Last Month Rule, you must remain an eligible individual (covered by HDHP) for the next 12 months, so through December 1st of the following year. If you fail to remain an eligible individual (change insurance plans, lose insurance plan, receive other health coverage) during that time, any “excess” contributions you made as a result of using the Last Month Rule will be taxed and penalized.
If you contribute per the Last Month Rule and end your HDHP insurance before the Testing Period ends, excess contributions will be taxed and incur a 10% penalty.
In this case, “excess” contribution are amounts you contributed in violation of the Testing Period. Said another way, you contributed more based on the Last Month Rule, and the Testing Period required you to maintain HSA eligible insurance for one year. You did not fulfill this year, and you will have to subsequently recalculate what your contribution limit would have been and pay taxes / penalty on the difference. You can see this on the Form 8889 Instructions in Section 3, Line 18.
Calculating Last Month Rule Penalty
Using the Form 8889 Instructions, use the Line 3 Limitation Chart and Worksheet to calculate what your actual contribution limit was for the prior year, not using the Last Month Rule. For example, if you started HSA eligible insurance on August 1st, you would fill out (yearly) contribution limits for August, September, October, November, and December, then divide by 12. This number ($1396), your allowable contribution limit, will be compared to the contributions you made via the Last Month Rule.
Likely, you previously contributed more than you were allowed. The difference is your excess contribution resulting from failing the Testing Period, and this line will be entered on Line 18 of Form 8889. This excess contribution amount invokes a penalty for violating the last month rule in both 1) tax (your marginal tax rate, say 25%) + 2) penalty (10%). This flows through back to your taxes by 1) adding back this income to your taxable income and 2) assessing an additional penalty in Section 3 of Form 8889.
Testing Period Examples
Here are some examples to demonstrate how the Testing Period works:
Example 1 – no problem
Paul is covered by an HSA family insurance on December 1st. He is able to take advantage of the Last Month Rule and does, contributing the maximum to his HSA for that year even though he only had coverage for one month. He does not change plans for many years so passes the Testing Period, which lasted until 12/1 of the following year.
Example 2 – coverage type problem
George was covered by single HSA coverage from January – November, but on December 1st changed to family plan HSA coverage. Using the Last Month Rule, he contributed the full family amount for the year ($6,650) to his HSA. However, he ended his HSA eligible insurance in November of the following year, meaning he failed the Testing Period at its end on the following December 1st.
Example 3 – ending coverage problem
John is covered by a single HSA eligible insurance plan on December 1st. He is able to take advantage of the Last Month Rule and does, contributing the maximum to his HSA for that year even though he only had coverage for one month. He continues making monthly average contributions (contribution limit / 12) for 6 months until June 30th, when he switches jobs and no longer has HSA insurance. As a result, he is no longer an eligible individual during his Testing Period. He has made 18 monthly average contributions during 7 eligible months, so he now needs to declare 11 of those as income during the year and pay a 10% tax on that amount. His calculations are:
Contribution made = $3,350
Allowable contribution = $279 ($3,350 * 1/12)
Excess Contribution = $3,071
Taxes due = $768 ($3,071 x 0.25 tax rate)
Penalty = $307 ($3,071 x 0.1 penalty rate)
Effects of the Last Month Rule / Testing Period
In the above examples, the account holders were taking a calculated risk that they could satisfy the Testing Period of the following year. You can see the tax/penalty is substantial for failing it. Thus, while powerful, the Last Month Rule can be a double edged sword. Some effects are:
+ Can make full year contributions during years of partial coverage
+ Jump start contributions to your HSA
+ Can reduce your taxes in the year you sign up for an HSA
– Risk over contributing and invoking taxation + 10% penalty
Determine your risk
When making a decision about a Last Month Rule situation, consider the following which may negatively affect you during the Testing Period :
How likely are you to change jobs during the Testing Period? Will your future employer offer HSA plans
How likely are you to change plans during the year, do to changes in status or partner’s plan?
How likely is your employer to change your health insurance options during the Testing Period?
Perhaps the safest strategy is waiting until the following year (but prior to April 15th) to make a Prior Year Contribution. This ensures you do not over contribute during a period and have to declare and pay tax on an amount. The strategy here is to save monthly amounts in a non-HSA account, and after the fiscal year (but before April 15th), contribute the money to your HSA as a prior year contribution.
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Note: if you are having trouble with the Last Month Rule, please consider using my service EasyForm8889.com to complete Form 8889. It is fast and painless, and asks simple questions no matter how complicated your HSA situation.
Jan 2015 update: I am finishing work on TrackHSA, a free service to help manage your Health Savings Account. Track purchases, upload receipts, and record reimbursements for all HSA purchases to help you minimize your taxes and satisfy the IRS. Sign up today.
One nice feature of your Health Savings Account is that you have some leeway as to when you are allowed to make contributions for a given year. We know that there is a contribution limit established each year ($3,300 / $6,550), but you don’t necessarily have to contribute any of it during that fiscal year.
That is because you can make prior year contributions to your Health Savings Account up until the tax filing deadline, which is usually April 15th of each year. A prior year contribution is simply a contribution that applies to the prior year’s contribution limit.
So for example, I could open an HSA in 2013 and not contribute a dime the entire year. On April 15th, 2014 I could contribute the maximum amount of $3,300 towards my HSA and designate that it apply to my 2013 contribution limit.
Said another way, even though we are in year 2014, I am contributing to my HSA in 2013, up to the contribution limit. The key is that, whenever you make a HSA contribution between January 1st and April 15th of a given year, there is an option on your HSA providers form to apply it to the previous year. Make sure to select the previous year if that is when you wish to apply the contribution.
Benefits of Prior Year Contributions
Catch up – The ability to make prior year contributions gives you the opportunity to catch up and fill your HSA if you are under your contribution for a given year. That way, you don’t miss any possible contributions and you can grow your HSA as much as possible.
Flexibility – While in theory funding and investing your HSA as early in the year is preferable (more time to grow), making a prior year contribution provides additional flexibility in that you have 3.5 extra months to find and contribute that cash.
Tax Planning – Any income you contribute to an HSA is tax deductible, meaning you don’t need to pay taxes on it. Thus, if you estimate your tax bill and find you have a tax burden, you can shelter some of that money from taxes by contributing to your HSA.
Likely, this rule was implemented because it makes no difference to the IRS what year your contribution goes towards as long as it is made prior to filing taxes. You can use this “loophole” to your benefit in the aforementioned ways.
