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Retirement Perspectives

In the second part of a three-part series, we explain the rules for eligibility, contributions, and distributions.

Experts expect health care costs to continue to rise, underscoring the importance of Health Savings Accounts (HSAs) to help defray those costs. As discussed in Part One of our series about HSAs, contributing to an HSA can help defray the cost of both unexpected and/or future health care expenses (i.e. deductibles, co-pays, out-of-pocket, non-covered services, etc.) on a tax-free basis. In Part Two, we’ll examine the rules for eligibility and distributions. It’s important to know the conditions for who can establish and fund an HSA, how the funds can be spent, distribution timing, and penalties for certain distribution, and additional requirements about how the funds are used at the time of distribution in order to preserve tax-free treatment.

HSA Eligibility
Similar to other tax-advantaged accounts, HSA establishment requires an investor to jump through a few hoops. First, HSA eligibility requires an employee to be enrolled in a high deductible health plan (HDHP). A HDHP saves an employee money on insurance premiums, therefore, we believe it’s wise to take the savings and fund an HSA.

To be HSA eligible, the HDHP for 2019 must have an annual deductible of at least $1,350 for individual coverage and $2,700 for family coverage. These are the same limits that applied for 2018. In addition, the out-of-pocket maximum may not exceed $6,750 for individual coverage and $13,500 for family coverage. Notably, the deductible counts toward the out-of-pocket limit.  

Features of an HDHP include, but are not limited to:

  • Higher annual deductible than typical health plans.
  • Maximum limit on the sum of the annual deductible and out-of-pocket medical expenses that you must pay for covered expenses. Out-of-pocket expenses include co-payments and other amounts, but do not include premiums.
  • An HDHP may provide preventive care benefits without a deductible or with a deductible below the minimum annual deductible.

Along with enrolling in an HDHP, there are other eligibility requirements. These requirements include: not being enrolled in any other health coverage (i.e. a spouse’s plans, unless that plan is an HSA eligible plan); cannot be claimed as a dependent on another person’s tax return; and most importantly, you cannot be enrolled in Medicare.

To qualify for an HSA, the following criteria must be satisfied. An individual:

  • Must be covered by an HDHP.
  • Must have no other health coverage except what is permitted under “Other” health coverage (see IRS Publication 969, “Health Savings Accounts and Other Tax-Favored Plans,” for more info).
  • Cannot be claimed as a dependent on someone else’s tax return.
  • Cannot be covered by Medicaid, Medicare, or another health plan this is not an HDHP.

Tip: If you qualify for an HSA, you cannot set up both an HSA and Flexible Spending Account (FSA), unless the FSA is a “limited purpose” FSA. A “limited purpose” FSA works like a regular FSA, but can be used only for vision care and dental expenses.

Notably, when an individual reaches age 65 and enrolls in Medicare, he or she forgoes their HSA eligibility. In other words, once enrolled in Medicare, you are no longer allowed to fund an HSA, although you can continue to take tax-free distributions to cover qualified medical expenses. Turning 65 does, however, provide benefits. While an HSA distribution is generally subject to a 20% penalty if the proceeds are not used for qualified medical expenses, the penalty is waived for those individuals aged 65 and older who used their HSA for nonqualified medical expenses. But such a distribution is subject to income taxes.

HSA Contributions
Each tax year that you have coverage provides the opportunity to contribute to your HSA up to your contribution limit. In addition, in the same vein as IRAs, the IRS permits prior-year HSA contributions in the following tax year. Further, contributions can be made by the HSA owner, employer, or anyone, and are subject to annual limits. There are additional unique attributes, such as that there is no requirement to have earned income, no income test to satisfy, and all contributions can be deducted from federal income taxes.

Tip: Annual HSA contribution amounts are generally pro-rated for the number of months the individual is enrolled in an HDHP.

In 2019, the maximum funding limit for an HSA is $3,500 for single coverage ($4,450 for those aged 55-plus) and $7,000 for family coverage ($8,000 for those aged 55-plus). Notably the “base” contribution limits are indexed for inflation, whereas the age 55 catch-up limit is not. The contribution deadline is the employee’s tax-filing deadline, not including extensions. Therefore, you still have time to make a 2018 HSA contribution. For 2018, the contribution limits are $3,450 (single coverage) and $6,900 (family coverage), plus an additional $1,000 catch up for those individuals age 55 and older.

As previously mentioned, taxpayers can make prior year contributions to their HSAs. Therefore, it’s imperative, just like prior year IRA contributions, that it’s clearly communicated to the HSA custodian that it is a prior year contribution. Otherwise, a contribution made in January will be used for the current year. The deadline for a 2018 prior-year contribution is the day your taxes are due, generally April 15. You can make contributions to your HSA for 2018 through April 15, 2019.

Tip: An individual does not need to remain an eligible individual to make a prior-year contribution. For example, your HSA-eligible insurance can end, but you can still wait until the following year to make prior-year contributions.

 


Source: Society for Human Resource Management

HSA Distributions
HSA owners can at any time (including after they retire and are no longer contributing to an HSA) distribute funds tax and penalty free to pay for qualified medical expenses (QMEs). Common QMEs include most medical, dental, vision, and prescription medication. Notably, tax-free distributions can be used to pay for a spouse’s or dependent’s medical expenses in addition to their own. For a complete overview, see IRS Publication 969, “Health Savings Accounts and Other Tax-Favored Plans,” and IRS Publication 502, “Medical and Dental Expenses.”

HSA also offer the flexibility to take a tax and penalty-free distribution in the current year for a previous year’s medical expense as long as the HSA was established prior to the expense. This tremendous benefit offers an account balance to accrue tax deferred for years or even decades with assets being distributed tax free for medical expenses!  For example, Denise’s HSA was first established in January 2005 and is currently valued at $25,000. Denise can take a tax and penalty-free distribution for any previous qualified medical expense incurred after January 2005 up to the value of her HSA ($25,000).

Tip: Although contributions are deductible on one's federal income tax, this is not always true for state income tax. In other words, a few states do not conform to federal legislation—thus they do not recognize HSAs, so contributions are not deductible and earnings are taxable. Check with your tax professional for details.

On the other hand, nonqualified distributions (those not used for medical expenses) are taxable and subject to a 20% penalty tax (as opposed to the more familiar 10% penalty tax associated with most tax-advantaged accounts). Interestingly enough, though, in the case of distributions taken after age 65 (not 59½), the 20% penalty is waived (though nonqualified distributions over age 65 are still taxable). Therefore, after age 65, a non-qualified HSA distribution is taxed in the same manner as a traditional IRA: funds are subject to income tax only. Remember, HSAs, unlike IRAs, are not subject to lifetime required minimum distributions.

Part 1 explains how advisors can help clients learn how to use HSAs.

Part 3 covers rollovers, beneficiaries, and other rules.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

About The Author

WEBINAR
 

videoJoin our conference call with Brian Dobbis in a discussion about Roth accounts, IRA strategies, and other retirement trends on Wed., Mar. 27 at 4:15 pm ET.

*Financial professionals only.
Earn CE credits (1 CFP credit).

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