With the cost of providing employee health care benefits continuing to rise, a health savings account (HSA) might offer an appealing tax saving strategy to utilize. For eligible individuals, HSAs offer a tax-favorable way to set aside money (or have their employer do so) to pay medical expenses. To be eligible for an HSA, you must be covered by a high-deductible health plan.
What is a High-Deductible Health Plan and What are the Contribution Limits?
For 2016, a high-deductible health plan is a plan with an annual deductible of at least $1,300 for self-only coverage, or at least $2,600 for family coverage. For self-only coverage, the 2016 limit on tax deductible contributions is $3,350. For family coverage, the 2016 limit on deductible contributions is $6,750. Additionally, annual out-of-pocket expenses required to be paid (other than for premiums) for covered benefits cannot exceed $6,550 for self-only coverage or $13,100 for family coverage.
If an individual or their covered spouse has reached age 55 before the close of the tax year (and is an eligible HSA contributor), an additional "catch-up" contribution for 2016 of up to $1,000 may be made.
A high-deductible health plan does not include a plan if the plan's coverage is for accidents, disability, or dental, vision, long-term care, insurance for a specified disease or illness, or insurance paying a fixed amount per day (or other period) of hospitalization.
HSAs may be established by, or on behalf of, any eligible individual.
What are the Limits for Deductions?
You can deduct contributions to an HSA for every month that you have qualifying coverage, that is, if you don’t have such coverage for the entire year. For 2016, the monthly limitation on deductible contributions for a person with self-only coverage is 1/12th of $3,350. For an individual with family coverage, the monthly limitation on deductible contributions is 1/12th of $6,750. For example, if you were to change jobs in July of 2016, and you became immediately eligible to open an HSA. Assuming you opened the HSA and were covered by a high deductible health plan (single coverage) from July through December, you’d be able to make a tax deductible HSA contribution of $1,675 ($3,350/12 months x 6 months of coverage) for 2016.
Also, taxpayers who are eligible individuals during the last month of the tax year are treated as having been eligible individuals for the entire year for purposes of computing the annual contribution. Although, after eligibility and transfer of funds conditions are met, the owner must pass the “testing period.” The testing period lasts for the entire tax year after the tax year in which the HSA was created. During this period, the owner must not become ineligible to make contributions to his HSA for any reason or there will be a tax penalty levied. Changing health plans is one circumstance that can make an owner ineligible. Along with a 10% tax penalty, the recapture rule will force the owner to report the contributions, which had originally been treated as tax deductible, as taxable income.
However, if an individual is enrolled in Medicare, they are no longer an eligible individual under the HSA rules, and so contributions to an HSA can no longer be made. Contributions can be made to an HSA by or on behalf of an eligible individual even if that person did not receive any compensation, or if the contributions exceed their compensation. Contributions made by a family member on behalf of an eligible individual to an HSA, which are subject to the aforementioned limits, are deductible by the eligible individual in computing adjusted gross income.
What if Your Employer Funds the HSA Contributions?
If you are an eligible individual, and your employer contributes to your HSA, the employer's contribution is treated as employer-provided coverage for medical expenses under an accident or health plan and is excludable from your gross income up to the deduction limitation. In addition, the employer contributions are not subject to withholding from wages for income tax or subject to FICA or FUTA. However, the eligible individual cannot deduct employer contributions on his federal income tax return as HSA contributions or as medical expense deductions, since the employer is taking the deduction.
An employer that decides to make contributions on its employees' behalf must make comparable contributions to the HSAs of all comparable participating employees for that calendar year. If the employer does not make comparable contributions, the employer is subject to a 35% tax on the aggregate amount contributed by the employer to HSAs for that period. Contributions are comparable if they are either the same amount or the same percentage of the annual deductible limit under the high-deductible health plan covering the employees.
An exception to the comparable contribution requirements applies for contributions made on behalf of non-highly compensated employees. Under this exception, an employer can make larger HSA contributions for non-highly compensated employees than for highly compensated employees. The latter would include the business owner(s) and/or family members.
Employer contributions are also excludable from income if made at the election of the employee under a salary reduction arrangement that is part of a cafeteria plan (a plan which allows you to elect to use part of your salary towards a variety of employee benefits). Although contributions to an employee's HSA through a cafeteria plan are treated as employer contributions, the comparability rule does not apply to contributions made through a cafeteria plan.
Are the Earnings on Your HSA Account Taxable?
If the HSA is set up properly, it is generally exempt from taxation, and there is no tax on earnings. However, you may be subjected to additional taxes if you over-contribute, required reports are not provided, or you use the funds for ineligible medical expenses.
Are Distributions from my HSA Account Taxable?
Distributions from the HSA to cover an eligible individual's qualified medical expenses, or those of his spouse or dependents, are not taxed. Qualified medical expenses for these purposes generally mean those that would qualify for the medical expense itemized deduction. If funds are withdrawn from the HSA for other reasons, the withdrawal is taxable. Additionally, an extra 20% tax will apply to the withdrawal, unless it is made after reaching age 65, or in the event of death or disability.
Distributions from an HSA exclusively to pay for qualified medical expenses are excludable from the gross income of the account beneficiary even though the beneficiary is no longer an "eligible individual," for example, if the person is over age 65 and entitled to Medicare benefits, or no longer has a high-deductible health plan. In addition, you cannot use HSA funds for medical expenses you incurred prior to opening an HSA account.
What You Can Do Before April 15th
If you were eligible to make an HSA contribution for any of 2015, the deadline to make your contribution is April 15, 2016 (adjusted for weekends and holidays). You will need to open an account and make the contribution by April 15, 2016 in order for it to be deductible on your 2015 tax return (same deadline as for IRA contributions).
To understand how an HSA may help you, contact me at email@example.com or any of the professionals in our tax department at 216-831-0733 for more information.