There are right ways and wrong ways to use the money in a Health Savings Account (HSA). In most cases, people use an HSA card that only permits them to pay for eligible purchases. No risk of penalties there.
But what about when people take cash out of an HSA and use it (either intentionally or unintentionally) for ineligible purchases?
Different types of penalties
There are two different penalties that can result when people withdraw money from an HSA. Which penalty you face depends on what you use the money for and when you make the withdrawal.
The tax penalty for ineligible purchases
You can submit a withdrawal request form to receive funds (cash) from your HSA. If the cash is used to pay for ineligible purchases, it must be reported when you’re filing your taxes. Once it’s reported, it’s subject to an income tax and treated as though it had never been in your tax-free HSA.
Example: You took a withdrawal of $100 out of your HSA to pay for new shoes. Your tax rate is 25%. When you report that $100, it will be taxed at 25% and you will only get $75 on your tax return.
However, there is no tax penalty to make withdrawals to cover qualified medical expenses. In other words, if you had spent the money on an eligible purchase (like orthotic inserts) your refund would have included the full $100.
The tax penalty for those under age 65
If you use the distribution for ineligible expenses before age 65, you are penalized twice.
First, you get hit with the income tax penalty. Second, you have to pay a 20% tax penalty for removing the money before age 65. Ouch.
Example: You took out $2,000 from your HSA to make a down payment on a new apartment because things went south with your roommate.
Sounds like it was an extreme situation and you didn’t really have a choice. You shouldn’t have to pay the penalty, right?
Unfortunately, while that may be true, even dire circumstances don’t protect you from the double penalty.
You would have to report the $2,000 used for unqualified expenses. The first penalty of 25% will knock the $2,000 down to $1,600. The second penalty will take an additional $320, leaving you with only $1,280.
A withdrawal AFTER age 65
After age 65, you can use your HSA withdrawal for non-medical expenses without paying the 20% tax penalty. New flat screen TV? Beach house deposit? Check, check… But only once you turn 65.
However, you do still have to pay the income tax on the distribution. Can’t win ’em all…
How do you avoid penalties?
The only way to fully avoid all penalties is to only use HSA withdrawals to make eligible purchases.