Tax-favored Health Savings Accounts (HSAs) Are More Popular Than Ever
One reason: when enacted, the Affordable Care Act (ACA) eliminated all two-or-more-employee, small-business health plans that reimbursed individually purchased health insurance.
The alternatives chosen by most business owners with fewer than 50 employees were to offer either:
- No health coverage, or
- HSAs in some form or other.
And for those businesses that offered no health coverage or had no employees, the owners frequently set up HSAs only for themselves.
In one significant respect, the ACA set the stage for small businesses—with or without employees—to hop on the HSA bandwagon.
Growing Popularity
According to a survey released in March 2023 by Devenir, an HSA industry participant based in Minnesota, the number of HSAs as of the end of 2022 surpassed 35 million, and the accounts held about $104 billion in assets.
These numbers represent year-over-year increases of about 9 percent in the number of accounts and about 6 percent in the amount of HSA assets, despite investments that suffered from last year’s poor stock market performance.
Devenir projects that by the end of 2025, the number of HSAs will approach 43 million, with $150 billion in assets.
HSA contribution and withdrawal activity has been substantial. In 2022, account owners contributed $47 billion (up 11 percent from 2021) and withdrew $34 billion (also up 11 percent from 2021).1
Bottom line: It’s fair to say that HSAs have gone mainstream. If you’re eligible to open one, it’s probably a good idea to do so, for reasons we will explain. With that thought in mind, onward.
HSA Basics
To have an HSA, you first need high-deductible health insurance. Once you have the insurance, you can contribute to the HSA, a unique savings-retirement-medical payment account.
For 2023, you can make a deductible HSA contribution of up to $3,850 if you have qualifying high-deductible, self-only insurance coverage, or up to $7,750 if you have qualifying high-deductible family coverage (which includes anything other than self-only coverage).
In the case of a married couple, if either spouse has family coverage, both spouses are considered to have only family coverage.2
For 2024, maximum contributions will be $4,150 for self-only and $8,300 for family.3 If you are age 55 or older as of yearend, the maximum deductible contribution goes up by $1,000.
You must have a qualifying high-deductible health insurance policy—and no other general health coverage—to be eligible for the HSA contribution privilege. For 2023,4 a high-deductible policy is defined as one with a deductible of at least $1,500 for self-only coverage or $3,000 for family coverage.5
For 2024, the minimum deductibles will be $1,600 and $3,200, respectively.
For 2023, qualifying policies can have out-of-pocket maximums of up to $7,500 for self-only coverage or $15,000 for family coverage.6
For 2024, the out-of-pocket maximums will be $8,050 and $16,100, respectively.7
The tax benefits of HSAs for an individual taxpayer are as follows:8
- You deduct your annual contributions to the HSA.
- Your earnings inside the HSA grow tax-free.
- You withdraw HSA money tax-free to pay qualified health care expenses.
Nice! Now for the details.
Contribution Tax Rules
You can make contributions to your 2023 HSA through April 15, 2024. This is the same deadline as for IRA contributions.
The write-off for HSA contributions is an above-the-line deduction.9 That means you can take the write-off whether you itemize or not. More good news: you don’t lose the HSA contribution privilege if you are a high earner.
If you are covered by qualifying high-deductible health insurance, you can make contributions and collect the resulting tax savings—period. Of course, this assumes you meet all the other HSA eligibility rules explained later in this article.
But you cannot make HSA contributions if you can be claimed as a dependent on another person’s federal income tax return for the year in question.10
Use Form 8889, Health Savings Accounts (HSAs), to determine your allowable annual HSA contributions.11
General Month-by-Month Eligibility Rule
According to the general rule, you determine eligibility to make HSA contributions on a monthly basis. So, if you have qualifying high-deductible health coverage for only part of the year, you can contribute and deduct 1/12 of the annual limitation amount for each month that you have qualifying coverage.12
More specifically, you are eligible for any month that you are covered by a qualifying high-deductible health plan as of the first day of that month.
Big Exception
But there is a big exception to the general month-by-month eligibility rule. If you are eligible to make HSA contributions as of the final month of the year, you can treat yourself as eligible for the entire year and contribute up to the maximum amount for that year.13
Although the ability to make a full HSA contribution based on end-of-year eligibility is theoretically attractive, the reality is that a harsh recapture rule can bite you if you become ineligible for HSA contributions during the subsequent “testing period.”
The recapture amount equals the additional contributions that you deducted under the eligibility exception compared to the pro-rated amount that would have been allowed under the general month-by-month eligibility rule. The recapture amount is taxable, and you will also be subject to a 10 percent penalty tax.14 Ouch!
The testing period begins with the final month of the tax year for which you made the enhanced contribution and ends on the final day of the 12th month following that month. The recapture amount is included in income, and the 10 percent penalty is charged, for the tax year that includes the first day during the testing period that you become ineligible for HSA contributions.
Bottom line: You can run afoul of the dreaded recapture rule if you cease to be eligible to make HSA contributions anytime during the year that follows the year you take advantage of the eligibility exception.
Example
On December 1, 2023, you obtain a qualifying high-deductible health plan that provides self-only coverage. You are 45 years old. You can make a deductible HSA contribution of up to $3,850 for your 2023 tax year (the maximum allowable amount for an individual your age with self-only coverage).
Thinking this is a great tax-saving deal, you do it.
Had you not done it, the rules would limit your 2023 contribution to $321 ($3,850 ÷ 12), one month out of 12. So far, so good: you deducted $3,850.
But if you become ineligible for HSA contributions anytime in 2024, you must report recapture income of $3,529 ($3,850 – $321) on your 2024 Form 1040 and pay a 10 percent penalty tax of $353 (10 percent x $3,529) to boot.
If the recapture and penalty look like a possible outcome, temper your enthusiasm for the larger HSA deduction this year.
Deductions for High-Deductible Health Insurance Premiums
If you run your business as a sole proprietorship, a single-member LLC treated as a sole proprietorship for tax purposes,
a partnership, or an LLC treated as a partnership for tax purposes—or if you are a shareholder-employee of your own S
corporation—you can usually claim a separate above-the-line deduction for 100 percent of your high-deductible health
insurance premiums.15
Remember, you need high-deductible health insurance coverage to create eligibility for the HSA. Generally, you deal
with two different companies: one for health insurance and one for the HSA.
Using the HSA Money
If you use HSA distributions to pay your qualified medical expenses or those of your spouse or dependents, the distributions are federal-income-tax-free.
You are allowed to build up a balance in the account if contributions plus earnings exceed withdrawals for medical expenses. Any income earned in the account is federal-income-tax-free. So if you are in very good health, you can use your HSA to build up a substantial medical expense reserve fund over the years while earning tax-free income.
Suppose you have an HSA balance after reaching Medicare eligibility age. One option: you can drain the account and pay federal income taxes without suffering the 20 percent penalty tax. Also, there is no penalty on withdrawals after disability or death.16
Alternatively, you can use your HSA balance tax-free to pay uninsured medical expenses incurred after reaching Medicare eligibility age. That’s a good deal.
If the HSA still has a balance when you die, your surviving spouse can take over the account tax-free and treat it as his or her own HSA, as long as you name your spouse as the beneficiary of your account.17
In other cases, the date-of-death balance of the HSA must generally be included in taxable income on that date by the person who inherits the account.18
To summarize thus far, an HSA can work a lot like an IRA if you can maintain good health and avoid big medical bills. Even if you must drain the account every year to pay uninsured health costs, the HSA arrangement allows you to pay those expenses with pre-tax dollars.
Warnings and Update for HSA
Warning 1: You cannot take tax-free HSA withdrawals to reimburse yourself for medical expenses incurred before you open the account. That’s logical.
Warning 2: If you take money out of an HSA for any reason other than to cover eligible medical expenses, you will be taxed on the withdrawal and will owe a 20 percent penalty tax to boot unless you’ve reached Medicare eligibility age.19
Warning 3: You can’t use your HSA money to pay insurance premiums unless the premiums are for:20
-
- Long-term care insurance,
- Health care continuation coverage (such as coverage under COBRA),
- Health care coverage while receiving unemployment compensation under federal or state law, or
- Medicare health insurance coverage if you are 65 or older (other than premiums for a Medicare supplemental policy).
Update: In response to the winding-down of the COVID-19 mess, the IRS has eliminated some COVID-related testing, treatment, and preventive care expenses that could temporarily be covered without a deductible by a qualified high-deductible health plan.21
Impact of Other Health Coverages on HSA
You may not make an HSA contribution for any month that you are also covered under any non-high-deductible health plan that provides coverage for any benefit covered under the high-deductible plan.22
For purposes of this rule, you can ignore the following types of health-related coverages:
- Plans that provide only preventive care benefits23
- Workers’ compensation insurance
- Insurance for a specific disease or illness (such as cancer insurance)
- Insurance that pays a fixed amount per day or per other period of hospitalization (so-called hospital benefit insurance)24
Beware: HSAs and Health Care FSAs Don’t Mix
According to the IRS, HSAs and health care flexible spending accounts (FSAs) don’t mix. Specifically, you cannot contribute to both accounts in the same tax year.25
As explained earlier, you may not make HSA contributions if you are covered by another health plan that is not a high-deductible health plan if that other plan provides coverage for any benefit that is also covered by the high-deductible plan.
Because a health care FSA that reimburses for qualified medical expenses without restrictions (a so-called general-purpose health care FSA) counts as another health plan, coverage under such an FSA makes you ineligible to make HSA contributions for the entire health care FSA plan year.26
Even worse, the IRS says you are considered covered by a health care FSA for the entire FSA plan year if you have any carryover into that year of an unused health care FSA balance from a prior year—even if you make no health care FSA contribution for the current plan year.27
Therefore, according to the IRS, if you have a carryover into the current plan year, you are ineligible to make an HSA contribution for the entire current plan year.
How to Establish an HSA
An HSA is an IRA-like trust or custodial account that you can set up at a bank, an insurance company, or any other entity the IRS decides is suitable—such as a brokerage firm.
The HSA arrangement must exclusively pay the account owner’s qualified medical expenses. These include uninsured costs incurred by the account owner (the person for whom the HSA is established), his or her spouse, and his or her dependents.
Otherwise, HSAs are subject to rules very similar to those that apply to IRAs. For example, you can make HSA contributions for a particular year as late as April 15 of the following year (extended for weekends and holidays). So, if you are an eligible individual for the 2023 tax year, you have until April 15, 2024, to establish an HSA and make a deductible contribution that you can claim on your 2023 Form 1040.
Use Form 5305-B (Health Savings Trust Account)28 or Form 5305-C (Health Savings Custodial Account)29 to set up an HSA. The forms are model trust and model custodian account agreements, respectively. Each one takes only a moment to complete. The completed Form 5305-B or 5305-C is not filed with the IRS. Instead, keep it with your permanent tax records.
HSA Investment Options and Providers
In theory, HSAs can offer the same investment options (stocks, mutual funds, bonds, CDs, and so forth) as IRAs offer.
That said, some HSA trustees may limit investment choices to very conservative options, which is not necessarily a bad thing.
You can find HSA trustees via an internet search, and some brokerage firms—including Fidelity and Vanguard—offer ways to set up HSAs.
Takeaways
- Growing popularity: HSAs are booming, with over 35 million accounts holding about $104 billion in assets at the end of 2022. This trend is expected to continue, reaching 43 million accounts with $150 billion in assets by 2025.
- HSA basics for 2023 and 2024: For these years, the deductible HSA contributions have been set at $3,850 and $4,150 for self-only coverage, and $7,750 and $8,300 for family coverage, respectively. If you’re 55 or older by the end of the year, you can contribute an extra $1,000.
- Tax benefits: HSAs offer substantial tax benefits, allowing users to deduct annual contributions, accumulate earnings tax-free, and withdraw funds tax-free for qualified health care expenses.
- Contribution and distribution rules: Contributions can be made up to April 15 of the following year, similar to IRA contributions. Withdrawals for medical expenses are tax-free, but penalties exist for non-qualified withdrawals.
- Health care FSAs versus HSAs: You cannot contribute to both an HSA and a general-purpose health care FSA in the same tax year.
- Establishing an HSA: HSAs are similar to IRAs in their structure and rules. They can be established through a bank, an insurance company, or another suitable entity, and contributions can be made up until April 15 of the following year.
- Investment options: HSAs can offer diverse investment options such as stocks, mutual funds, and bonds, similar to IRAs. But trustees may restrict options to a conservative portfolio.
- Overall: The tax benefits they offer make them an attractive option for many individuals and business owners. If you qualify, it might be time to consider setting up an HSA.