Is a health saving account (“HSA”) right for you? Find out in the article below which summarizes what a HSA is, who is eligible to establish one, types of expenses that can be paid with HSA funds, increases to HSA limits in 2013 and how health care reform changed the way HSAs are used.
I. What is an HSA?
A HSA “is a tax exempt trust or custodial account,” which is set up through a qualified HSA trustee or insurance company.1 HSAs first became available in 2004 through the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“MMA”).2
An HSA can be contributed to, by or on behalf of, “eligible individuals,” as defined below, and is used to pay for certain medical expenses for the eligible individuals, their spouses and their tax dependents. For eligible individuals, HSAs offer the following numerous benefits:
The funds contributed to an HSA are set aside tax-free to be used for qualified medical expenses;
employer contributions to an employee’s HSA are excluded from income and employment taxes;3
an individual can claim an “above the line” tax deduction for any contribution made to the HSA;4
an individual can decide exactly how much to set aside for medical expenses;
an individual can use the money in his or her HSA for a variety of health care expenses which health insurance plans may not cover, including dental expenses like cleanings and braces, vision care, and alternative treatments like acupuncture;
an individual’s contributions remain in his or her HSA from year to year until they are used;
interest and other earnings in an HSA are tax free; distributions from an HSA may be tax free if used for a qualified medical expense;
an HSA is portable, so it travels with an individual as he or she changes employers or leaves the work force.5
II. Who is Eligible to Establish an HSA?
You must be an eligible individual to qualify for an HSA. To be HSA-eligible, an individual must meet the following four requirements:
An HSA is only available to an individual who is enrolled in a high-deductible health plan (“HDHP”)6 for the months in which contributions are made to the HSA.7
An individual cannot have other health coverage, except for a few permitted “other health coverage”8 exceptions.9
An individual cannot be enrolled in Medicare.10
An individual cannot be claimed as a dependent on someone else’s tax return.11
III. Types of Expenses that can be Paid with HSA Funds
HSA distributions are entirely voluntary, and HSA distributions are generally available without restriction. This means, an individual can pay any expense with his or her HSA funds. Specifically, IRS Notice 2004-2 states “an individual is permitted to receive distributions from an HSA at any time.”12 While an individual can always access the funds in his or her HSA, the tax treatment of a distribution will depend on the timing of the distribution and whether any unreimbursed medical expenses can be used to offset the distribution.
An HSA distribution is excluded from an individual’s gross income and tax-free if used for the qualified medical expenses of an account holder, his or her spouse, and tax dependents. A “qualified medical expense” is an “expenditure for medical care, as defined by §213(d), for the account holder and his or her spouse or tax dependents, to the extent that such accounts are not reimbursed by insurance or otherwise.”13 Typically, a distribution to pay for insurance premiums is not tax-free.
If a distribution is made from an HSA for nonmedical expenses, those distributions will be included in an individual’s gross income and will be subject to an additional 20% tax (this 20% additional tax took effect beginning with the 2011 tax year. This is an increase from 10% that applied for tax years prior to 2011).14
IV. IRS Increases to HSA Limits in 2013
HSA contributions may be made by an HSA account holder, or other individuals including the account holder’s spouse, tax dependents and employer.15 The amount that can be contributed to an individual’s HSA depends on factors, including the type of HDHP coverage the person has, the individual’s age16 and date of eligibility.1718 Limits on HSA contributions apply to an individual account holder based on his or her taxable year. The same annual limits apply regardless of who makes an HSA contribution.19 Changes to these limits are around the corner as the IRS has announced increases to HSA account limits, effective in 2013. HSA limits will adjust each year for cost of living.
The current 2012 maximum contributions for HSAs are $3,100 for individuals and $6,250 for families.20 However, the maximum contributions for both individuals and families will be increasing slightly in 2013, according to the IRS.21 Under IRS Revenue Procedure 2012-36, the maximum contributions that can be made to HSAs in 2013 will increase to $3,250 for employees with individual coverage and to $6,450 for employees with family coverage.22 It is important to note that HSA account fees are not treated as an HSA contribution, and therefore are not calculated in the maximum contribution.23
In addition to the rise in maximum contribution, the IRS has also announced a simultaneous rise in the minimum deductable for all HDHPs, which HSAs must be linked to.24 In 2013, the minimum deductible will rise from $1,200 to $1,250 for employees with individual coverage and from $2,400 to $2,500 for employees with family coverage.25
Finally, the maximum out-of-pocket expense, which includes but is not limited to an employee’s deductibles, will also rise in 2013.26 For employees with individual plans, the maximum out-of-pocket expense will rise from $6,050 to $6,250, and for employees with family plans it will increase from $12,100 to $12,500.27
No changes will be made to the HSA catch-up contributions.28 Therefore, the 2012 $1,000 HSA catch-up contribution limit will carry-over to 2013.29
If HSA contributions exceed the limits imposed by law, an individual will be subject to an excise tax of 6% for each taxable year in which excess contributions are made.
V. How Health Care Reform Changes the Way HSAs are Used
Health care reform, specifically the Patient Protection and Affordable Care Act ("ACA”)30 has changed the way HSA accounts are used in two ways. Significantly, ACA has: (1) added a prescription requirement for the reimbursement of over-the-counter (“OTC”)31 medicines and drugs, other than insulin;32 and (2) increased the amount of penalty for nonmedical expense distributions from an HSA as more fully explained below.33
ACA establishes new restrictions on reimbursement for OTC34 drugs and medicines if purchased in tax years after December 31, 2010. According to these new restrictions, HSAs can only provide tax-free distributions for medicines and drugs if they are prescribed,35 with the exception of insulin.36 This is true even if a prescription is not necessary to acquire the medicines or drugs. The new health care reform restrictions do not apply to OTC items that are not drugs or medicines (i.e. medical devices, equipment, crutches, blood sugar test kits and eyeglasses). Under ACA, if distributions are made from an HSA for nonmedical expenses, the distribution will be subject to a 20% tax.37 This increase applies to all distributions made for tax years after December 31, 2010. As previously discussed, this is an increase from 10% that applied for tax years prior to 2011.
(1) See IRS Publication 969 (2011), Health Savings Accounts and Other Tax-Favored Health Plans.
(3) See Code §§106(d), 3231(e)(11), 3306(b)(18), and 3401(a)(22).
(4) See Code §62(a)(19).
(5) See IRS Publication 969 (2011), Health Savings Accounts and Other Tax-Favored Health Plans.
(6) An HDHP is a health insurance plan with high deductibles but lower premiums than traditional health insurance plans.
(7) See IRS Publication 969 (2011), Health Savings Accounts and Other Tax-Favored Health Plans.
(8) Generally, an HSA eligible individual cannot have other health coverage. But, an individual can have additional insurance that provides benefits only for the following items: liabilities incurred under workers’ compensation laws, tort liabilities or liabilities related to ownership or use of property; a specific disease or illness; and a fixed amount per specified period for hospitalization. An individual may also have coverage for: accidents; disability; dental care; vision care; and long-term care.
(12) Only reasonable restrictions on frequency or amount of distributions from an HSA are permissible by the IRS.
(13) See Code §223(d)(2); IRS Notice 2004-2, 2004-2 I.R.B. 269, Q/A-26, See also IRS Notice 2004-50, 2004-33 I.R.B. 196, Q/As-26 and 028.
(14) See Code §223(f)(2) and (4) as amended by PPACA, Pub. L. No. 111-148, §9004(a)(2010)(applicable to distributions made after December 31, 2010).
(15) See IRS Notice 2004-50, 2004-33 I.R.B. 196, Q/A-28.
(16) Known as “Catch-up Contribution.”
(17) Known as “The Last-month Rule.”
(18) See IRS Publication 969 (2011), Health Savings Accounts and Other Tax-Favored Health Plans.
(19) See IRS Notice 2004-2, 2004-2 I.R.B. 269, Q/A-12 and IRS Notice 2004-50, 2004-33 I.R.B. 196, Q/A-28.
(20) See Geiser, Jerry Workforce, Health Savings Account Contribution Caps to Rise Slightly in 2013, available at http://www.workforce.com/article/20120427/NEWS01/120429965/health-savings-account-contribution-caps-to-rise-slightly-in-2013 (April 27, 2012).
(23) See IRS Notice 2004-50, 2004-33 I.R.B. 196, Q/A-71.
(24) See Geiser, Jerry Workforce, Health Savings Account Contribution Caps to Rise Slightly in 2013, available at http://www.workforce.com/article/20120427/NEWS01/120429965/health-savings-account-contribution-caps-to-rise-slightly-in-2013 (April 27, 2012).
(28) See Paton, Jenn, FosterThomas, Health Savings Account (HSA) Changes for 2013, available at http://www.fosterthomas.com/blog/bid/53573/Health-Savings-Account-HSA-Changes-for-2013 (May 24, 2012).
(30) See Patient Protection and Affordable Care Act, Pub. L. No. 111-148 (2010), as amended by Health Care and Educational Reconciliation Act of 2010, Pub. L. No. 111-152 (2010).
(31) A “prescription drug” is defined as a “drug that can be obtained only by means of a physician’s prescription,” while “OTC” is a term used to describe “a drug that is sold lawfully without a prescription.” See U.S. National Library of Medicine, MEDLINEplus: Medical Dictionary (as visited Oct. 12, 2012).
(32) Under the ACA, non-prescription insulin will still be considered qualified medical expenses, and therefore disbursements for insulin will be tax-free.
(33) See Patient Protection and Affordable Care Act, Pub. L. No. 111-148 (2010), as amended by Health Care and Educational Reconciliation Act of 2010, Pub. L. No. 111-152 (2010).
(34) OTC drugs are not taken into account when determining an individual’s medical expense deduction under Code §213. See §213(b).
(35) “Prescription” is defined as “a written or electronic order that satisfies the legal requirements for a prescription in the state in which the expense is incurred, including t hat it be issues by someone who is legally authorized to issue a prescription in that state.” See IRS Notice 2010-59, 2010-39 I.R.B. 396.
(36) See Code §106(f), as added by ACA, Pub. L. No. 111-148 (2010).
(37) Code §§ 223(f)(4)(A) and 220(f)(4)(A) as amended by ACA, Pub. L. No. 111-148(2010).