HSAs Offer Trifecta Tax Benefit: Contributions, Growth and Distributions

A previous column discussed why many federal employees and retirees should consider enrolling in a high deductible plan (HDHP) offered through the Federal Employees Health Benefits (FEHB) program during this benefits open season (Nov. 12, 2018 through Dec. 10, 2018).

Associated with many HDHPs are Health Savings Accounts (HSA). HSA owners can benefit when it comes to taxes in three ways, namely:

1. HSA owner contributions to HSAs are tax deductible on the owner’s Federal income tax return  as an “adjustment to income”;
2. earnings (interest or dividends) accrue in the HSA at least tax-deferred and may be withdrawn tax-free; and
3. distributions of contributions and accrued earnings from the HSA are tax-free if used to pay for qualified medical, dental and vision expenses.

The HSA therefore offers potentially a trifecta tax benefit (tax deductible contributions, tax-free growth, and tax-free distributions) to the HSA owner.

SEE ALSO:

• Why Federal Employees Should Consider High Deductible Health Plans
• How to Get the Most Out of Your Savings by Using an HSA

HSA Contribution Limits

Each year, the IRS announces a limit on the amount an HSA owner may contribute to an HSA. For 2019, the limit is:

• HDHP with self only coverage – $3,500;
• HDHP with self plus one or self and family coverage – $7,000.

HSA owners age 55 and older during 2019 may contribute an additional $1,000.

How a FEHB program-sponsored HDHP associated with an HSA works

1. An employee or annuitant enrolls through the FEHB program in an HDHP;
2. The HDHP establishes an HSA with a fiduciary;
3. Each paydate, the HDHP contributes some of the HDHP insurance premiums into the employee’s or annuitant’s HSA (the “premium-pass-through”); and
4. During the year and until the individual income tax filing deadline of April 15,  the employee or annuitant (the HSA owner) can make additional tax-deductible contributions into the HSA, up to the maximum allowed according to IRS HSA contribution limits for that year.

Employees and annuitants can view the premium-pass-through amounts for 2019 that each HDHP plan contributes each month to their HSA associated with the FEHB-sponsored HDHP plan, by going to OPM’s website here. As an example for 2018, one FEHB plan (GEHA) offers an HDHP in which monthly premiums are $296.36 for self and family coverage, $269.42 monthly for self plus one coverage, and  self only monthly premiums are $125.31. The following table shows the 2018 monthly premiums and “premium-pass-through” for GEHA HDHP plans:

The following examples show the premium-pass-through for GEHA HDHP for 2018:

Example 1.  Robert, a single federal employee, age 45 is enrolled in GEHA HDHP self only coverage during 2018. Robert’s total FEHP premiums over 12 months will be 12 times $125.31, or $1,503.72. Of Robert’s $1,503,72 premiums and the federal government’s contributions, $62.50 monthly, or $750 per year,  is contributed to Robert’s HSA. Since Robert can contribute a maximum of $3,450 to his HSA during 2018, Robert can contribute from his own money $3,450 less $750, or $2,700, to his HSA for 2018. The $2,700 he contributes will be fully deductible on Robert’s 2018 federal income tax return as an “adjustment to income”.

Example 2. Julie, a federal employee, age 56, is enrolled in GEHA HDHP self plus one coverage during 2018. Julie’s total FEHP premiums over 12 months will be 12 times $269.42 or $3,233.04. Of Julie’s $3,233.04 premiums and the federal government’s contributions, $125 per month, or $1,500 per year, is contributed to Julie’s HSA. Since Julie can contribute to her HSA a maximum of $7,900 ($6,900 plus $1,000 additional), Julie can contribute $7,900 less $1,500 or $6,400 to her HSA for 2018. The $6,400 she contributes will be fully deductible as an “adjustment to income”.

Transfer Funds from Traditional IRA to HSA

There is another way that an HSA owner can fund his or her HSA. An individual is allowed to transfer funds from a traditional IRA to an HSA, up to the remaining contribution amount allowed for they year, but with some restrictions. This HSA funds mechanism via a traditional IRA is called a qualified HSA funding distribution, or “QHFD” for short.

A QHFD is a tax-free rollover (but not tax deductible) of traditional IRA funds to an HSA. The IRA owner is permitted to shift taxable IRA assets to an HSA which can be withdrawn from the HSA tax-free in order to pay qualified medical, dental or vision expenses. Since the rollover is tax-free, there is no 10 percent early withdrawal penalty, no matter the age of the IRA owner.

A QHFD is not subject to what is called the IRA “pro-rata” rule which is applied when a traditional IRA owner converts his or her traditional IRA to a Roth IRA. What this means is that a traditional IRA owner who has both before-taxed and after-taxed funds in his or her traditional IRA (often called a “nondeductible” traditional IRA) and uses a QHFD, can specify that only the taxable portion of the IRA be part of a QHFD. This could make a future Roth IRA conversion more attractive or it could mean that a larger distribution will be tax-free.

A QHFD can also be made from a traditional IRA that an individual was named a beneficiary, an “inherited” IRA. The QHFD will have the same restrictions with an “inherited” IRA as one’s own IRA.

The IRA funds can be moved to the HSA account only as a direct transfer. The funds cannot be moved as a 60 day rollover. There are other restrictions and limitations for a QHFD, including:

1.  An individual may only perform one QHFD in his or her lifetime. Individuals with multiple traditional IRAs can still do only one QHFD;
2. the amount of a QHFD in any year is limited to the amount that one can contribute to an HSA. The amount that a Federal employee or annuitant can contribute to an HSA is limited to the difference between the HSA contribution limit for that year and the premium-pass-through amount that year; and
3. unlike an HSA owner’s cash/check contribution to an HSA, a QHFD is not deductible as an “adjustment to income”.

If there is a need, an HSA owner with multiple traditional IRAs can combine the IRAs in order to be able to transfer the maximum amount. For example, suppose in example 2, above, Julie owns two traditional IRAs with balances of $3,000 and $5,000. Julie wants to do a QHFD in 2018 for her HSA contribution limit of $6,400 but neither of her IRAs holds that amount. Julie therefore combines the IRAs and now has one IRA worth $8,000. She can then do her QHFD of $6,400 from the one IRA which has a balance of $8,000.

One exception to the one time QHFD rule is for individuals who have self only coverage on the first day of the month in which the QHFD occurs but who switch to self plus one or self and family coverage later in the year. In that case, the individual can make an additional QHFD to cover the difference between the self only contribution limit and the self plus one/ self and family contribution limit for that year.

Some other restrictions on QHFDs:

• The transfer can come from an HSA owner’s traditional IRA, Roth IRA, inactive SEP or inactive SIMPLE IRA;
• The transfer can only go between IRAs and HSAs owned by the same individual;
• The funds transferred must be before-taxed funds only; and
• While the use of Roth IRA funds for a QHFD is permitted, it will be extremely limited. This is because a Roth IRA consists mostly of after-taxed dollars such as Roth IRA contributions. But a Roth IRA owner younger than age 59.5 would pay income tax on any accrued earnings withdrawn from the Roth IRA. This means that a Roth IRA owner younger than age 59.5 could directly transfer Roth IRA earnings to an HSA via a QHFD.