Who knew that using your HSA was going to be difficult? Actually, using an HSA is the easy part. It is the tax reporting tied to an HSA which sometimes presents challenges. You start reading tax forms and need to answer, “Did you have a normal distribution for your HSA?”
“Hmmm… what is a normal distribution? Are there abnormal transactions? How does one know?”
Clearing up the terms
Legislators and regulators seem to love their jargon. So let’s start with a few definitions.
Distributions = Any money taken out of the HSA (also referred to as a withdrawal)
This is where it gets a little technical. There are five different classifications of HSA distributions.
Normal Distribution = This is going to be the most common type. It is used for all the routine use of the HSA. This includes when HSA funds are used for medical items or services. Think bandages, doctor’s visits, hospitalizations. The list goes on. Check out these resources for more info on what are eligible expenses?.
Excess Contribution Removal = This is a “make it right” type of transaction. It is used when you have deposited more to the HSA than the IRS limits allow and you must remove the extra deposits.
Prohibited transaction = These are going to be very uncommon. A prohibited transaction occurs when the use of your HSA funds disqualifies it from being an HSA, such as pledging your HSA assets as collateral for a loan.
Disability = This is uncommon, but is used when money is taken from the HSA after you as a participant are disabled.
Death distribution = This one is more for the people in your life to know how to handle things after your passing. A death distribution can be made to a spouse, an estate or an individual other than a spouse following the death of the participant. If you want to be in control of what happens to your HSA funds, be sure to Designate a Beneficiary.
Let’s talk taxes
Each HSA distribution type has a specific purpose and, specific tax treatment considerations.
Eligible medical expenses = tax-free
The good news is that by default most transactions are going to be considered normal distributions. This means you enjoy all the tax-advantages of the HSA and remain completely tax-free. If you used your HSA funds for eligible medical expenses as intended, you are in the clear.
When “normal distributions” are taxable (maybe)
This is where is gets even more complicated. But, we will attempt to break it down with a couple scenarios. In each of the scenarios, you decide to take money out of your HSA to fund your latest passion (boats, cars, purses, tech gadgets, etc.).
Scenario 1: Under age 65 with no unpaid medical expenses. You will need to report the ineligible expense. It will be subject to normal tax, plus an additional 20% tax penalty.
Scenario 2: Under 65 with previous medical expenses. You will report the medical expenses and reimburse yourself from the HSA. The HSA funds remain tax-free. There is no time limit on when you can take a distribution. It can even be years later.
Scenario 3: Over 65 with no unpaid medical expenses. You will need to report the ineligible expense. It will be subject to normal tax. However, there is no additional 20% tax penalty once you reach age 65.
Scenario 4: Over 65 with previous medical expenses. You will report the medical expenses and the funds will remain tax-free.
Removing an excess = Normal tax treatment
Like we said, an Excess Contribution Removal is a “make it right” transaction. It removes the excess and any interest earned from the HSA and your standard tax rates apply. The key is to make sure you fix it before filing your taxes for the year. There is a 6% excise tax is you fail to remove the excess in a timely manner.
Death, disability and prohibited transactions = It’s complicated
There are many nuances and scenarios that affect uncommon distributions, such as death, disability and prohibited transactions. It is best to consult a qualified tax adviser to ensure these transactions are properly handled and managed. However, a couple points to keep in mind:
- An HSA can be transferred to a spouse without paying taxes.
- An HSA transferred to anyone other than a spouse is a taxable event and it is no longer treated as an HSA.
- Funds used in an HSA for eligible medical expenses are always tax-free.
Back to the beginning
Remember, when you’re going through tax forms, start by answering, “Did I have a normal distribution for my HSA?” The answer will probably be yes.
In the event it’s not, review distribution types, see if one applies, and consult a tax adviser to make sure you have the information right.