Many people like Health Savings Accounts (HSAs). They save on taxes and set aside money for medical expenses. When you join an HSA-qualified health plan and sign up for an HSA, you put pre-tax money into an account. You can then withdraw the funds for qualified healthcare expenses. The IRS defines these expenses. HSA withdrawals are tax-free and penalty-free if used for eligible expenses.
Many HSA owners wonder if they can use the money for nonqualified expenses. If so, would they incur a withdrawal penalty?
First, let’s review some HSA basics.
HSA Basics
An HSA mirrors a Flexible Spending Account in its operations. Contributors make before-tax contributions to HSAs. This means that your paycheck deducts the funds before taxes. This reduces your taxable income and saves you money. You and your family can use these funds to cover out-of-pocket healthcare expenses. You will not be taxed or penalized for HSA withdrawals as long as you use the money for qualified expenses.
One significant advantage of an HSA is that you own the account—like a checking or savings account. You can keep and use the money even if your employment status changes. Additionally, there are several ways to grow the account over your lifetime.
The money in your HSA earns interest tax-free. You can also invest HSA dollars to help the balance grow. This lets you enjoy tax-free investment returns. Plus, an HSA does not have a “use it or lose it” rule. Any remaining balance rolls over to the next year. You don’t lose any unused funds in the account.
Non-Qualified Expenses and the HSA Withdrawal Penalty
Using Your HSA in Retirement – No Penalty
An HSA has a big perk. Once you reach age 65, you can take an HSA distribution for any expense. And you won’t face a penalty. The only thing to note is that the government will tax the withdrawal as regular income. HSA dollars spent on eligible expenses, like Medicare premiums, are not taxed. This is the same as before retirement.
You can roll over HSA funds each year. So, contributions that exceed expenses can grow large by the time of retirement. Many people have low to moderate healthcare expenses. They use their HSA as a retirement account.
If you use the money for nonqualified expenses before the age of 65, there is a withdrawal penalty.
IRS Penalty and Taxable Income
Before age 65, using HSA funds for nonqualified expenses results in a 20 percent penalty. The IRS imposes a penalty on the withdrawn amount. For example, if you spend $500 on nonqualified expenses, your penalty will be $100.
The IRS will also add a 20 percent penalty. They will also tax any HSA funds spent on nonqualified expenses. When filing taxes, you must include them in your total income. They could increase the amount you owe or reduce any refund you are entitled to.
How can I avoid unqualified expenses?
Ask your HR department or benefits administrator first. They can help you avoid spending HSA dollars on unqualified medical expenses. Research and learn more about eligible expenses. For example, most prescription medications qualify, as do over-the-counter drugs. However, some items do not meet the rules published by the Internal Revenue Service. Always save your relevant documents and receipts to verify expenses.
Are there safeguards in place to protect me?
If you are using an HSA debit card, some places offer safeguards. The safeguards ensure that qualified items receive the funds.
- IIAS: Many pharmacies, supermarkets, and other approved locations use an inventory control system. It’s programmed to know which expenses are eligible and which are not. If you attempt to buy an ineligible item, the card company may decline your card.
- MCCs identify approved locations. They also show which ones are not approved. They prevent accidental usage at non-approved places, such as restaurants or bus stations.
Mistakes can still occur. Your HSA card may lack these security features. It depends on your administrator or employer. This could cause an accidental ineligible transaction. Always double-check which card you use for purchases.
Mistake Forgiveness
The IRS allows some leeway for honest mistakes. You can return the money to your HSA account if you can show “clear and convincing” evidence. The evidence must show that someone made a mistake by spending on a nonqualified expense. That way, you can avoid the HSA withdrawal penalty. For example, if you assumed a healthcare product or procedure met the qualifications. But, you later found it wasn’t. The IRS will let you return the money to your account. You can do this if you can show you made an honest mistake.
HSA owners must keep all their receipts. Whether you purchase with a benefits card or another method is crucial. A paper trail helps when filing for reimbursement. It also helps track buying details (date/time, amount, location). This is important in case of an IRS audit.
HSA Facts You Should Know
Like many financial accounts, HSAs can seem complex. They are confusing, especially when opening one for the first time. Luckily, many online sources can help you learn and get your questions answered. Here are some frequently asked questions:
Can anyone open an HSA account?
No. HSAs have specific eligibility requirements. In addition to being enrolled in an HSA-qualified health plan, you must also:
- Be at least 18 years old.
- Have no other non-high-deductible health plan medical coverage.
- Not enroll in Medicare.
- Not claim yourself as a dependent on someone else’s tax returns.
Can other people contribute to my HSA?
Yes, others may contribute to your HSA as long as you meet the enrollment qualifications. Many employers offer contributions as part of their benefits package. You could also receive contributions made on your behalf by family members or others. Both your contributions and others’ count toward the annual limit.
If I change jobs, will I lose my HSA account?
No. Unlike FSAs, your HSA stays with you for life unless you choose to close it. Whether your employer sponsors the account or you opened it on your own, this holds true. This feature makes HSAs effective for saving and investing. It also helps add to your retirement nest egg.
Is there a time limit on submitting a claim for reimbursement?
No. There is no hard time limit. You only need to follow the rule that you incurred the expense after opening the account. You can submit a reimbursement claim at a later date, even months or years later. For instance, if you open the HSA in January 2025. You can reimburse any eligible expense years later. It has to occur after that date. However, you could not take an HSA withdrawal for an expense prior to the January 2025 open date.
