HSAs: Practical Tax Considerations

In football parlance, health savings accounts (HSAs) would be considered a triple threat. Contributions to these health care accounts reduce taxable income, grow tax free, and qualify for tax-free withdrawals for health care uses.

Created under Public Law 108-173 in 2003, HSAs are one type of health-related, tax-advantaged accounts that include health flexible spending arrangements (FSAs), Archer medical savings accounts (MSAs), and health reimbursement arrangements (HRAs). At a basic level, an HSA is a tax-advantaged account that individuals can use on unreimbursed medical expenses, including deductibles, copayments, coinsurance, and other services not covered by insurance.

An HSA is a tax-exempt trust (until the account ceases to be an HSA – see prohibited transactions later) or custodial account that is set up and funded with a qualified HSA trustee.¹ It is not, in itself, health insurance. An HSA may receive contributions from an eligible individual or any other person on behalf of that eligible individual, including an employer or family member.²

Employer contributions are not only excluded from an employee’s gross income, but they are also excluded from Social Security, Medicare, and federal unemployment taxes. The same treatment applies for employee contributions made through a cafeteria plan. However, no employee tax filing deduction is allowed for HSA contributions made through a cafeteria plan, but individuals may take an above-the-line deduction for amounts contributed to their HSAs during the year if not done through payroll.

IRS Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans, notes that an individual must be covered under an HSA-qualified high deductible health plan (HDHP) for HSA contribution eligibility (among other requirements). An HDHP has a higher annual deductible than typical health plans, and a 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 copayments and other amounts, but do not include premiums.

HSA balances can be invested similarly to IRAs, and any associated earnings accumulate tax free. Unlike a retirement account, though, an HSA has no required minimum distribution considerations. HSA accounts are portable, too. They are owned by the individual, not the employer or insurer, and can be moved to another trustee if desired.

To keep the federal tax benefits, there are several explicitly prohibited transactions. These are similar to those for IRAs and can disqualify an account. For example, an account beneficiary may not sell or lease property to an HSA, borrow from an HSA, furnish goods, services, or facilities to an HSA, or pledge HSA assets as collateral.

Federal Tax Reporting

When participating in an HSA, clients must file federal Form 8889. In brief, Form 8889 reports on HSA contributions (including those made on the account holder’s behalf and employer contributions), distributions, and the determination of the HSA deduction. Form 8889  also calculates the amount of income and additional tax owed if the holder fails to maintain HDHP coverage and/or received an HSA distribution for nonqualifying medical expenses.

Thus, in completing Form 8889 for a client, the following should be considered: Form W-2 (for pretax contributions), Form 1099-SA (for distributions), and Form 5498-SA (for all contributions made to an HSA for a given year).

Taxpayers who make deductible contributions to an HSA for federal income tax purposes can claim the same deduction on their Pennsylvania income tax returns. Taxpayers should complete PA Schedule O, Other Deductions, Section III, to report the deduction.

If claiming the deduction, taxpayers must attach the following federal forms and/or schedules to their Pennsylvania tax returns:

• Form 1040, Pages 1 and 2
• Form 1040, Schedule 1
• Form 8889

HSA distributions that are not subject to federal income tax are not subject to Pennsylvania income tax. However, any federally taxable HSA distributions are also taxable in Pennsylvania and should be reported as interest income on Form PA-40, Schedule A. Unlike the federal treatment, Pennsylvania does not impose an additional tax on distributions not used for qualified medical expenses. 

¹ Banks, insurance companies, and approved IRA and Archer MSA trustees are automatically eligible to serve as HSA trustees. Other entities must request IRS approval.

² The direct payment of an individual’s medical expenses is generally not subject to gift taxes. However, contributions to another person’s HSA account are not exempt medical expenses. These HSA contributions are taxable gifts which, when coupled with other amounts gifted, could trigger a gift tax return filing. This might apply in many parent-to-child HSA contribution scenarios.