Guide to HSA Deductions and Fees

Your health savings account (HSA) is a tax-free safe space, where you can secure funds without fear of heavy tax hits when it's time to use the money for qualified medical expenses.

(After all, there's a good chance you're going to need $250,000 or higher at retirement, just for medical costs. Yikes.)

And if you're healthy, your HSA is an even better resource, letting you save contributions from your employer without having to claim them as taxable income. And any contributions you make on your own? Tax-deductible. Money that grows with you, without much (if any) tax season confusion? Sign us up.

A quick refresher on HSA basics...

In case you're new to all this, an HSA allows users to pay for current health care expenses and save for those in the future. Its first advantage is that contributions are tax-deductible, or if they're made through a payroll deduction, they're pre-tax. Second, the interest earned is tax-free. Third, account owners may make tax-free withdrawals for qualified medical expenses. That's a TRIPLE benefit (we should totally get a stamp or something).

HSAs are available with most high-deductible health plans (HDHPs). The primary objective of a health savings account is to give individuals an additional source to fund health costs that cannot be covered due to limitations imposed by their plan.

These accounts are usually compared to flexible spending accounts (FSAs). But, there are big (huge!) differences between these types of plans. One of the unique things about HSAs that's not incorporated into FSAs is the ability to roll over unused funds on a yearly basis. Bye, deadlines!

While money contributed to an FSA can no longer be accessed after the end of a plan year (or the end of a grace period or runout period, if your plan has one), money in an HSA will stay with you until you're ready to spend. In other words, your HSA can protect you -- like a healthy safety net -- even if your health care options aren't the best.

Using HSA funds the right way

In a perfect world, you'll stay 100%, completely healthy, and can save your HSA funds to add a huge boost to your retirement savings. Or you can talk with a financial professional and maybe push that money even further by investing it the right way.

But don't forget that HSA stands for HEALTH savings account -- they're designed to be there for when you might need it most. Emergencies, uninsured treatments, whatever -- your HSA is there to keep you from dipping into your own pockets for qualified health expenses.

(There's a lot of qualified expenses -- just check out this list to see what we mean.)

If you need to access your HSA funds, you can rest a little easier -- you won't be taxed on withdrawals if the funds are used to directly pay for medical expenses that aren't covered by your HDHP. For example, non-preventive care appointments, like additional eye care appointments, dermatologist screenings, dental visits and prescription meds, to name a few.

But there are some limits. If you choose to use your HSA funds to pay for non-qualified expenses (medical or otherwise), you could face some serious penalties. But we'll get to that in a different section.

Okay, let's talk tax deductions

You can claim federal tax deductions on your HSA by using IRS Form 8889 (don't worry, it's not much extra work). This quick step, along with your 1040, will let you claim deductions on out-of-pocket contributions to your HSA.

Any contributions you've made to your HSA which have been "out-of-pocket," meaning directly from you instead of your employer, are tax-deductible.

If you're not sure how to organize this, don't worry -- the IRS has Form 8889 to do just that. Using this pretty simple document, you'll:

  • Report your HSA contributions (and those from your employer).
  • Figure out your HSA deduction.
  • Report payouts from HSAs.
  • See if there's any amount that needs to be reported as income (along with additional taxes) in case something isn't eligible.

Using Form 8889, you'll have the opportunity to list separately the contributions you've made to your HSA and the contributions your employer has made. (Please note, this doesn't apply to contributions made pre-tax from your payroll throughout the year, if available through your employer to do so.)

After completing the steps you'll find your maximum deductible amount on Line 13. Once you begin completing your tax return with IRS Form 1040, you'll input the figure on Line 13 of Form 8889 into 1040 line 25. When you're done, you'll be able to successfully claim a deduction on your out-of-pocket HSA expenses.

Wait… slow down… can you tell me a little more about Form 8889?

Okay, let's get into this a little deeper, since filling out Form 8889 the right way prevents you from paying penalties and enables you to claim certain deductions.

If you hold an HSA (or are the beneficiary of a deceased account holder), you're required to attach Form 8889 to your Form 1040 when filing your personal tax return. If you don't, you probably can't deduct your HSA contributions.

Oh -- one important note: The IRS "Last Month Rule." Put simply, this means if you sign up for an HSA toward the end of the year, as long as the account is active by the first day of the last month of the tax year (let's just call it December 1 for argument's sake) you can make a full year's contributions at once.

Put even more simply -- Sign up for HSA in November, be active and eligible by December 1, and you're allowed to make HSA contributions for the whole tax year, if you want to do it.

Sure, that's a large sum of money to add, but if you're able to do it, it's a great way to maximize your benefit and savings in a minimal amount of time.

If you stop being eligible for an HSA -- like if you switched health plans and don't have an HDHP anymore -- you'll need to include the total contributions made to your account as part of your income. This additional income is subject to a 10% added tax (calculated toward the end of Form 8889).

Can you show me how to complete Form 8889?

Before we can walk you through any of this, you need to know that we're not tax professionals and this is not to be considered tax, investment or legal advice. If you have questions about filling out your taxes or proper use of your HSA, we always recommend that you speak with a qualified tax professional.

Before you file Form 8889, you need a few other documents filled out. It's kind of like playing the lower stages of a video game before you get to the final level. Only this has your real, hard-earned cash on the line so be thorough! This includes:

  • IRS Form 5498—contribution activity, provided by the HSA custodian
  • IRS Form 1099—distribution activity, provided by the HSA custodian
  • IRS Form 8853—reports contributions and payments from Archer MSAs and payments from long-term care insurance contracts, if applicable

W-2 Form—displays the amount of contributions made by your employer, if applicable

Once you've gathered your necessary paperwork, carefully follow the Form 8889 instructions line by line. One mistake could force you to start over if you're not careful. It really is the most punishing video game isn't it? Let's walk through the three primary parts of the form, using some guidance directly from the IRS, since it gets a little (a lot, sorry) technical.

Part I overview...

This portion of HSA Form 8889 covers contributions and deductions. Find the amount reported on Form 5498-SA and enter it in line 2; if your employer made contributions to your HSA, enter the amount reported on your W-2 on line 9.

Be sure to make note of the contribution limits on line 3; once you hit age 55, this number will change and should be accurately reflected on your Form 8889. Line 13 is also important—it's the amount of money you can deduct from your income per HSA tax law. This number will eventually be entered on Form 1040.

Part II overview...

This section of tax Form 8889 assesses your distributions and verifies whether it was spent properly.

Line 15 determines how much was spent on qualified medical expenses; any amount greater than box 14c will be penalized.

If the subtraction on line 16 is a positive number, you'll owe tax and penalty on the amount (20%).

Part III overview...

Part III of HSA 8889 determines whether you owe taxes and penalties for two possible reasons:

You utilized The Last Month Rule, then ended your HSA insurance plan early

You funded an HSA distribution from an IRA or Roth IRA

In most cases, these lines won't have any totals. But if you do have numbers on lines 18 and 19, combine their total on line 20 (and remember to include it on line 21 "Other Income" on Form 1040.

Do the same rules apply for both federal and state taxes?

As you probably know, HSAs offer the amazing triple-tax benefit (stamp is shipping) -- contributions are tax-deductible, the HSA balance grows tax-free (at least at the federal level) and funds can be withdrawn without being taxed when used for HSA-eligible expenses.

But (and you knew there would be one) there are a few exceptions at the state level to this triple-tax advantage. California and New Jersey currently don't allow tax-free contributions at the state level. And HSA earnings -- like those that come from investments -- are taxable in California.

While many states offer triple tax benefits, ones without a state income tax (Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming) don't allow for deductions for HSA contributions. Plus, in New Hampshire and Tennessee, HSA holders may have to pay taxes on any interest, dividends or capital gains earned in their accounts.

Long story short? Check with a financial advisor about any state-level rules and regulations before filing or claiming deductions. A little legwork now could save you a ton of extra work after the fact.

Making the most of your deductions

Since HSA contribution limits are in place, you may need to plan when trying to maximize your deduction. Say your employer contributes up to 90% of the maximum allowed total into your HSA, you won't be able to make any contributions on your own past the remaining 10% of the total.

To be honest, this might limit your deduction opportunities. So you should carefully scrutinize your options to determine what the perfect balance of contributions will be for your particular financial scenario.

Given the earnings potential of HSAs, you should work hard to use these accounts in the most efficient ways possible.

Now, about those HSA fees and penalties…

You might not notice small fees in your statements, but they can very quickly pile up. By the time you realize how much they're affecting your finances, the damage is already done. It's hard enough to get a handle on the fees associated with your bank and investment accounts, but it's twice as difficult with something like an HSA, which you probably use infrequently, and with a very limited understanding of the fine print.

Withdrawal penalties

But what happens when it's time to use this money? As healthy as you might be now, the purpose of an HSA is to serve as a financial safety net against unexpected emergencies, or larger medical costs you might face in the future.

HSA contributions aren't taxable, but if you withdraw the money for a non-qualified medical expense, you'll end up paying a 20% penalty and income tax on the distribution. If you're audited, a $500 withdrawal for a non-qualified expense would result in a $100 fee on top of whatever your tax rate is. If you're in the 15% tax bracket, you'll owe an extra $75 on top of the $100 fine.

If you're 65 and older, you can take HSA distributions for any reason and avoid the 20% penalty. The amount will still be reported as income, and the tax rate will vary based on your income.

Investment account fees

Many users choose to use their HSA as a secondary investment vehicle, but banks tend to charge a small monthly fee if you invest your HSA funds. Avoiding these fees is rare, but you can always pick an HSA provider with a lower fee, unless it's chosen for you by your employer.

If that's the case, and you want to have your HSA contributions taken pre-tax from your pay, you'll need to use whomever your employer has chosen.

On top of an automatic monthly investing fee, HSAs often charge trading fees - much like a traditional brokerage firm. Look into your trading fee options from your account administrator, so your investing dollars don't go toward unnecessary expenses.

Monthly HSA account fees

Since we're discussing it, let's not forget about the standard set of fees that come with HSAs (or any money-accruing account). HSA providers sometimes charge monthly account maintenance fees. But if you participate in an HSA through your employer, they'll often take care of these fees for you. Your enrollment paperwork should detail this, but if you're unclear, there's always the golden proverb: "check with your plan administrator."

Even if you're not participating, you can sometimes avoid the fee by keeping a minimum account balance. Of course, this varies; one well-known national bank has a $4.25 monthly service fee unless you have $5,000 or more in the account. Yet, a smaller competitor has no account fees or minimums.

Log on to your account and see if there's a monthly maintenance fee on your statement. If there is, call the bank and ask what you can do to avoid it. Some accounts start charging a fee if you switch employers and your account is no longer associated with your previous company (likely because your employer no longer pays the fee for you), so be aware of that possibility, as well.

In the end, if you have an HSA through an employer, fees are often taken care of. But if you've selected your own health savings administrator, and want to get the most out of your HSA, you need to be aware of the fees you're being charged, and how to avoid them.

This is just a guide -- always lean on a professional

We mentioned it earlier, but it goes without saying -- before you dive into your tax planning, be sure to speak with your employer, insurance provider and/or a qualified financial or tax advisor (or all of the above). Any of these professionals should be able to help you clearly understand what your needs are when it comes to documenting your contributions and making the right moves with your account.

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