Common HSA mistakes cost savers

Clients eager to use the benefits of health savings accounts must steer clear of all-too-common mistakes that could bring large tax payments or big penalties, according to experts.

Financial advisors and tax professionals can help clients avoid pitfalls by reminding them that the HSA advantages of duty-free saving, investment growth and withdrawals come with some strict guidelines, planner Kevin Thompson of Fort Worth, Texas-based 9i Capital Group and Health and Welfare Sales Consultant Cat Torres of Wakefield, Massachusetts-based Sentinel Group told Financial Planning. Potential mishaps include the most typical blunder around HSAs — distributing money toward costs that don’t fit the IRS definition of “qualified medical expenses” — and planning for a tax hit if a non-spouse beneficiary inherits an account.

HSA holders who spend money from their account for a nonqualified expense will pay up to 20% of the withdrawal amount as a penalty, Torres noted in an interview. And, if the IRS begins to review the HSA outlays, its auditors are more likely to begin probing other areas of a tax return in a way that “could be very time-consuming and expensive” for the client, she said.

“All of this is going to be included in your tax return. You don’t necessarily have to submit receipts or proof of the expense when you file your tax return,” she said. “They could go back and say, ‘OK, you withdrew $10,000 from your HSA last year. Can you show us the qualified expenses that this was used for?'”

READ MORE: HSAs come with pitfalls — here’s how to avoid them

Thompson counts himself “a huge proponent of HSAs,” but he counsels clients about the tax impact to any non-spouse heirs who may be in line to receive the assets, he noted. They could avert a potential tax bill to the beneficiaries by draining the accounts of assets to pay medical bills, assigning their HSA to a spouse in their estate plan or considering the use of trusts or charitable gifts, Thompson said.

“It’s 100% taxable. It basically becomes an IRA, but it’s an IRA that’s just immediately distributable to the person who inherits it,” he said. “That’s one of the few downsides.”

Another cautionary area revolves around Medicare, which is an allowable use of the assets for premiums but a potential snag for any clients expecting to work when they’re 65 or older. Customers at that age will have to pay taxes on any outlays that aren’t for a medical expense, but they aren’t subject to the penalties. 

In addition, experts recommend that HSA holders cut off any contributions from themselves and their employers for at least six months before applying for Medicare, according to an article in the Journal of Accountancy by personal financial coach Kelley Long.

“When taxpayers opt to continue working past age 65 and wish to continue funding an HSA, they need to be very clear on the Medicare rules of application and enrollment to avoid either penalties for excess HSA contributions or late-enrollment penalties for Medicare Part B and Part D,” Long wrote.

READ MORE: HSAs should be promoted as way to supplement retirement savings

Every year, the IRS keeps up with inflation by updating its definition of “high-deductible health plan” that enables participants to open HSAs and the total maximum contributions into the accounts. Sometimes, savers lose track of their contributions or don’t realize they have to restrict them under a prorated ceiling if they switch jobs, Torres noted.

“Not everybody is considering their employer contribution plus their payroll contribution — they all go toward that maximum,” she said. “We see that when people leave an employer midyear and they have that HSA from that prior employer and they want to try to maximize the triple-tax advantage of having that HSA. So they max out.”

HSA savers may also run into penalties if they, for example, expect to pay medical bills of $5,000 that only end up costing $4,200 and then forget to return the remaining money to the account, Torres said. 

“Everything can be fixed, and as long as you do it in that same tax year, you’re going to be OK,” she said. “There are remedies, so you want to stay on top of it. You can always put the money back and document that you’re putting it back because it’s a mistake.”