Understanding the Pitfalls of HSAs and Medicare

Those federal employees who are over age 60 and who own health savings accounts (HSAs) are familiar with their HSAs and have figured out how to use their HSAs to help pay their qualified medical expenses. They also know how to use their HSAs judiciously in order to save money to pay for future unanticipated health care expenses including during retirement.

However, there are important rules that an HSA owner in his or her early 60’s needs to heed in order to avoid being subject to an IRS penalty when the HSA owner enrolls in Medicare. This column discusses when an HSA owner must stop contributing to an HSA. Also discussed is how an HSA owner can continue to use HSA dollars to pay qualified medical expenses after the HSA owner enrolls in Medicare.

SEE ALSO: Why a Health Savings Account Can Be Valuable for Federal Employees & Retirees

First, a brief review of paying for qualified medical expenses in a tax-beneficial way when using an HSA. HSAs are associated with high deductible health plans to allow the HSA owner to pay for qualified medical expenses.

Tax Savings of HSAs

HSAs offer triple tax savings, namely:

(1) Contributions to the HSA are made with before-taxed dollars;

(2) HSA accrue earnings over time and when these earnings are withdrawn, they are tax-free when used to pay for qualified medical expenses; and

(3) Tax-free HSA withdrawals can be made before and throughout retirement to pay for qualified medical expenses. Qualified medical expenses during retirement include medical and dental care expenses not paid by insurance, long-term care insurance premiums, hearing aids, custodial care nursing services not covered by insurance, and the reimbursement for Medicare Part B and Part D monthly premiums.

Upon reaching age 65, an HSA owner can also make penalty-free withdrawals to pay for any nonqualified medical expense such as home repairs or personal expenses. However, full federal and state income taxes will have to be paid on these nonqualified withdrawals.

SEE ALSO: IRS Announces Big Increases in Health Savings Account (HSA) Contribution Limits

HSA Eligibility Rules

However, HSA eligibility rules state that an HSA owner cannot contribute to his or her HSA or receive any contributions from an employer to fund his or her HSA when enrolled in any part of Medicare. If any contributions are made to the HSA at any point after the HSA owner enrolls in Medicare, the HSA owner will be subject to an IRS excise tax penalty.

The following are illustrations of the rule when an HSA owner must cease making HSA contributions:

– An individual is currently contributing to an HSA and plans to enroll in Medicare the month before the individual becomes age 65.

₋ In that case, the individual must make sure all HSA contributions cease before the month the individual becomes age 65.

₋ Since Social Security and Medicare consider an individual to be “of age” as of the day before his birthday, an individual who has a birthday on the first of a month, he or she is considered to be “of age” as of the last day of the previous month. An HSA owner whose 65th birthday is on the first day of any month should therefore stop his or her HSA contributions by the beginning of the month before the month he or she becomes age 65.

– This rule has practical application for federal retirees enrolled in an HDHP associated with an HSA, with respect to changing their FEHB program enrollment. In particular, if a federal retiree is enrolled in an HDHP and knows that in the coming year he or she will become age 65, then the retiree should change his or her FEHP program enrollment to a non-HDHP plan.

The following example illustrates:

Example 1. Jenny, age 64, is a federal retiree enrolled in an HDHP associated with an HSA. In March 2024, Jenny will become age 65. During the current (2023) FEHB program “open season”, Jenny should change her FEHB enrollment to a non-HDHP health plan. The change of enrollment will become effective January 1, 2024.

Note that starting February 1,2024 Jenny will no longer be eligible to contribute to her HSA. However, she can continue to make tax-free withdrawals from her HSA to pay qualified medical expenses including reimbursing herself for Medicare Part B and Medicare Part D monthly premiums.

– An individual who continues to work past age 65 and enrolled in an HDHP associated with an HSA in which the individual and the individual’s employer contribute to the HSA.

₋ The individual should stop contributing to his or her HSA at least six months before applying for Medicare Part A or both Medicare Part A and Medicare Part B or starting his or her Social Security retirement benefits.

₋ When an individual over age 65 starts receiving Social Security retirement benefits, his or her Medicare Part A enrollment is backdated 6 months, but no earlier than the first month the individual is eligible for Medicare. This is in order to give the individual six months of back-dated Medicare Part A benefits. If an individual contributes to his or her HSA during those six months, the individual will face a 6 percent IRS excise tax and pay income tax on those contributions.

₋ The “6-month lookback” rule starts when an HSA owner over age 65 enrolls in Medicare or starts to receive his or her Social Security retirement benefits. However, to avoid the IRS excise tax penalty, the HSA owner should withdraw those HSA contributions by the end of the tax year.

This HSA restriction leads some HSA owners working past age 65 to defer enrolling in Medicare and maintaining their current employer-based health insurance coverage so that they can continue contributing to their HSA until they retire.

The following example illustrates:

Example 2. Sharon, age 64, is a federal employee enrolled in an HDHP associated with an HSA. Sharon will become age 65 in July 2024 but will continue working in federal service. She plans to retire on July 31,2026 at the age of 67. She will not enroll in Medicare Part A in July 2024 when she becomes age 65 because she wants to continue to contribute to her HSA.

When Sharon retires from federal service on July 31, 2026, she will enroll in Medicare Part A and Medicare Part B during the 8-month Special Enrollment Period (SEP) which runs from August 1,2026 through March 31, 2027. Sharon’s 6-month lookback period starts as of February 1, 2026.

This means that as of February1,2026, Sharon can no longer contribute to her HSA. She should change her FEHB program enrollment during the 2025 FEHB program “open season” starting in November 2025, and choose a non-HDHP health insurance plan. Her enrollment in the new FEHB program insurance plan will become effective January 1, 2026.

Be Aware of HSA Rules When Enrolling in Medicare

In summary, HSAs allow federal employees to pay for qualified medical expenses in a tax beneficial way. HSAs also allow employees to save in a tax-beneficial way in order to pay for qualified medical expenses in retirement.

Federal employees and retirees who are getting close to age 65 and therefore eligible for Medicare enrollment should be aware of the rules regarding HSAs and Medicare enrollment in order to not be penalized for making HSA contributions once Medicare coverage begins.