Tax Savings of Health Savings Account Distributions to Pay Medical Expenses

A recent column “Reaping Tax Benefits from Contributions to a Health Savings Account” discusses contributions to Health Savings Accounts (HSAs). HSA contributions are made with before-taxed dollars and result in federal and state income tax savings for an HSA owner in the year of contribution.

This column discusses the tax savings when HSA distributions are made to pay qualified medical expenses.Tax-free HSA distributions include both the HSA contributions and accrued earnings within the HSA.

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

HSA Distributions

When qualified medical expenses are reimbursed or paid directly from an HSA, the distributions are not taxable. Distributions that are not taxable include HSA contributions (which were made with before-taxed dollars) and HSA accrued earnings which have not been taxed.

In order to be a qualified medical expense, the expense must be:

1. Incurred after the HSA has been funded. It is important for employees enrolled in a Federal Employees Health Benefits (FEHB) high deductible health plan (HDHP) associated with an HSA (or any other HDHP associated with an HSA) that the HSA needs to have some funding in order for the HSA owner to be reimbursed from the HSA for qualified medical expenses.

The following example illustrates:

Jerry and Sharon are married. Sharon is a federal employee enrolled in an FEHB HDHP associated with an HSA covering herself and Jerry. Each pay period, a portion of Sharon’s HDHP insurance premium is automatically deposited into her HSA. As of February 1, 2023, there is $100 in her HSA. On February 2, Jerry gets a kidney stone and incurs a $2,500 medical bill. Jerry and Sharon may deposit the $2,500 into the HSA and then immediately withdraw the HSA funds to pay the doctor because the expense was incurred after the HSA was established. The $2,500 that they contributed to the HSA on February 10,2023 is deductible on their 2023 Form 1040 as an “adjustment to income” and the withdrawal is non-taxable because the withdrawal is for a qualified medical expense.

2. A medical expense that can be deductible as an itemized deduction is a medical expense that is not reimbursed or paid directly. This means that it is allowable as a medical expense and is paid for as a dependent.

3. Over-the -counter (OTC) medicine, whether or not prescribed, and menstrual care products.

4. Paid by the HSA owner, for the HSA owner, the HSA owner’s spouse or a child dependent and claimed on the HSA owner’s federal income tax return. Also included is a child that could have been claimed by the HSA owner as a tax dependent but did not because the child is married and files his or her federal income tax return as married filing joint (the child and their spouse have no federal tax liability; the only reason they are filing a married filing joint tax return is to get a refund of withheld federal income taxes). Another example is a child dependent claimed by someone else. Note that a child of a divorced parent qualifies even if the dependency was released.

Medical insurance premiums do not qualify for HSA tax-free reimbursement, except the following:

(1) Long-term care insurance – up to the allowable annual Schedule A (Medical and Dental expense) amounts;

(2) Medical insurance paid for a spouse or for a tax dependent while the latter is receiving unemployment;

(3) Medicare Part B premiums for the HSA owner (over age 65) or a spouse (over age 65); and (4) Medicare Part D premiums.

Note that no one reviews HSA distributions (including the HSA custodian) in order to determine if the HSA distributions are qualified. However, HSA owners are advised to make sure that HSA distributions are made to pay or reimburse for qualified medical expenses in case of IRS audit.

All HSA gross distributions made during the year will be reported to the HSA owner in January following the year of distributions on IRS Form 1099-SA. Box 1 (see sample Form 1099-SA below) and further reported on IRS Form 8889 (see below). HSA distributions that are not “qualified” or taxable and reported on IRS Form 1040, Schedule 1, line 8f are subject to a 20 percent penalty for HSA owners under age 65. HSA owners over age 65 are not subject to the 20 percent penalty for non-qualified HSA distributions.

Reporting HSA Distributions

IRS Form 1099-SA is used to report distributions from an HSA. A sample 1099-SA is shown here:

Information reported in Box 1, Box 2 and Box 3 of Form 1099-SA is explained:

Box 1: This box shows the amount distributed from the HSA, including both reimbursements to the individual and direct payments to medical providers. It will be taxable to the extent that the amounts distributed are not used to pay qualified medical expenses. This amount is reported on IRS Form 8889, line 14a (see below). The HSA owner enters the amount spent for qualified medical expenses on Line 15 of Form 8889 as shown here:

If an individual inherited an HSA from someone who was not his or her spouse, then the fair market value (FMV) of that account (Box 4) is reported on the individual’s Form 1040 in the year that the HSA owner died. This is true even if the individual received the HSA in a year subsequent to the year of the HSA owner’s death. Any earnings on the account after the date of death (Box 1 minus Box 4 of Form 1099-SSA) is taxable. The earnings are included on IRS Form 1040 Schedule 1, line 8f but are not subject to penalty.

Box 2: This box on Form 1099-SA shows the earnings on any excess contributions that were withdrawn from the account by the due date of the tax return. The earnings are taxable in the year of distribution, even if used for qualified medical expenses, and are also included in Box 1. The taxable earnings are included on line 16 of Form 8889 (see above) and then reported on Form 1040 Schedule 1, line 8f as “other income”. The excess contributions are subject to an excise tax calculated on IRS Form 5329 (Additional Taxes on Qualified Plans Including IRAs and Other Tax-Favored Account).

Box 3. The following codes in Box 3 identify the HSA distribution, if known:

1. Normal Distribution
2. Excess contributions
3. Disability
4. Death distribution other than Code 6
5. Prohibited transactions, and
6. Death distribution after year of death to a non-spouse beneficiary

State Tax Treatment of HSA Contributions, Earnings and Distributions

Almost all states that have state and local income taxes follow IRS rules regarding HSA contributions. But California and New Jersey do not permit pre-taxed contributions at the state level. HSA earnings are also taxable for California residents. All distributions for qualified medical expenses are not taxable at the state level for HSA owners living in states with state income taxes.

States with no state income tax do not provide a deduction for HSA contributions nor do these states tax HSA distributions. These states are Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Washington and Wyoming.

“Deemed” Distributions from HSAs During 2023

The following situations result in “deemed” distributions during 2023 from an HSA and are subject to federal income tax and a 20 percent penalty:

1. The HSA owner engaged in any transaction prohibited by Internal Revenue Code (IRC) section 4975 with respect to his or her HSA at any time during 2023. The HSA then ceased to be an HSA as of January 1, 2023. The HSA owner must then include the fair market value of all assets in the account, as of January 1,2023 on IRS Form 8889.

2. The HSA owner used any portion of his or her HSA as security for a loan at any time during 2023. The fair market value of the assets in the account used as security for the loan must be included as income on IRS Form 1040, form 1040-SRE or Form 1040-NR.

Examples of prohibited transactions using the HSA include the direct or indirect:

• Sale, exchange or leasing of property between the HSA owner and the HSA

• Lending of money between the HSA owner and the HSA

• Furnishing goods, services or facilities between the HSA owner and the HSA, and

• Transfer to or use by the HSA owner, or for the benefit of the HSA owner, of any assets of the HSA.

Any deemed distribution will not be treated as used to pay for qualified medical expenses. This distribution is included in the HSA owner’s income and is subject to a 20 percent IRS penalty if the HSA owner is under age 65.