Health savings accounts, or HSAs, are a godsend to certain families. If you and your family are in a relatively high tax bracket, with few other deductibles available to you, contributing to a health savings account can help you shelter a substantial amount of income over the years from taxes, while still contributing to your family’s overall economic security. This is actually one of the safer investment strategies for families (Read: 5 Critical Considerations Before You Begin Investing).
If you are eligible to contribute to a health savings account, you don’t get any tax benefits if you don’t actually make contributions. The good news is that the IRS recently announced increased contribution limits for tax year 2012:
For individual plans, you can contribute up to $3,100 in 2012. If you own a policy that covers you and your spouse, or you and your children, or both, you can contribute up to $6,250. That’s higher than the IRA limit for most people. In fact, if you make more than the IRA income limits and don’t have a workplace 401(k) or 403(b), your HSA, together with your home mortgage interest deduction, if applicable, could be among the last tax shelters you have left.
Take Advantage of Catch-Up Contributions
If you are over age 55, the law allows you to make additional “catch-up” contributions of up to $1,000 per year. Note the age cut-off for HSA catch-up contributions is different than for IRAs. IRA catch-up provisions begin at age 50. You’ll have to wait another 5 years to make catch-up contributions to your HSA.
Note, too, that this catch-up provision has increased substantially over the years. In fact, if you owned the plan since 2004, you should realize that the maximum allowable catch-up contribution has doubled.
Let it Grow, Let it Grow
Money in your HSA grows tax-deferred. You don’t have to worry about either income tax or capital gains taxes in your HSA, so long as you leave the money in the account. HSAs aren’t like flexible spending arrangements in workplace Section 125 “cafeteria” plans. You don’t give up unspent money at the end of the year in a health savings account. Instead, this money continues to grow and compound, tax-deferred, until you need it.
Do your best not to tap your HSA for anything other than qualified medical expenses. Recent changes to the tax law increased the excise tax penalty from 10 to 20 percent for HSA withdrawals for any reason other than to cover qualified medical expenses. That’s twice the penalty that’s imposed on early distributions from IRAs and 401(k)s.
Think about what Congress is telling you: They want you to tap your retirement account before you tap your HSA for living expenses.
On top of the 20 percent penalty, you’ll also have to pay income tax on the entire withdrawal. Including the penalty. The combination of federal and state income taxes, plus the 20 percent penalty, could easily eat up over half of your distribution before you get to spend a dime. A big part of your tax planning is avoiding these penalties.
Know the Rules
Another recent change to the law removed over-the-counter medications from the list of approved, qualified medical expenses. If you weren’t aware of the law, and you had been using your HSA dollars to buy allergy medicine, Pepto-Bismol, cold and flu medicine, aspirin, Tylenol, or anything else available without a prescription, you could be liable for income taxes and penalties, in the event the IRS challenges your expenditures.
You can’t use your HSAs to pay for medical insurance premiums, most of the time. You may, however, use your HSA to pay for long term care insurance premiums, COBRA continuation coverage, and health insurance coverage if you are on unemployment compensation.
Consider a Qualified HSA Funding Distribution
If you have an out-of-pocket medical expense that’s greater than your HSA balance, you may consider making a qualified distribution from an IRA to your HSA. You must do a direct trustee-to-trustee rollover – you cannot take possession of the funds yourself until after they have gone into your HSA, or you will owe taxes and penalties on the IRA distribution. But once that rollover goes into your HSA, you can use those funds to pay for medical expenses, tax-free. But beware: You can only make one qualified HSA funding distribution in your lifetime. For full details, see IRS Publication 969, Health Savings Accounts.
You don’t need to send your receipts for health care expenditures to the IRS every year. The IRS relies on taxpayers reporting any non-qualified expenditures themselves, and paying the penalty. However, there is always the chance you will be selected for an IRS audit – particularly if you own a business, you are self-employed, or you work in certain targeted professions, such as outside sales. If you cannot justify your expenditures as qualified medical expenses, you may be liable for interest and penalties – on top of the income tax and 20 percent excise tax penalty.
You cannot contribute to an HSA if you are also covered under Medicare. However, you are automatically enrolled in Medicare when you turn 65. At that point, you have a lot more flexibility in how you use your HSA dollars. There is no more 20 percent penalty, and you don’t have to worry about qualified vs. non-qualified medical expenses. You simply have to pay income tax on your distributions. In that sense, tax rules treat your HSA very similarly to IRAs and 401(k)s. Try not to take the amount in a lump sum: This could push you into a higher marginal tax bracket than necessary. One idea – You can use your unused HSA balance to pay your Medicare Part B, C and D premiums or long term care insurance premiums in retirement.
Even if you’re reading this during the new year, it may not be too late to contribute to your HSA for the previous year. Like IRAs, HSAs give you until the tax deadline – typically April 15th—to make HSA contributions for the previous year.