FAQs on HSAs

A version of this article originally published in December 2013.

Health savings accounts are a hot topic, based on the many comments and emails I receive about them. The accounts, used in conjunction with high-deductible health-care plans, enable you to make pretax contributions, enjoy tax-deferred compounding, and take tax-free withdrawals for qualified health-care expenditures.

For people who are already making the maximum contributions to 401(k)s and IRAs, there's a lot to like about yet another tax-sheltered investment vehicle. That's the key reason that I urge high-income earners to give the HDHP/HSA combo another look as they make their health-care selections each year.

But it's early days for HSAs. Individuals have been allowed to establish the accounts for the past decade, but the accounts only have begun to pick up steam in the past five years as HDHPs have become more prevalent. And many HSA programs are larded with various types of fees.

Would-be HSA investors also have many questions about the logistics of using the accounts, judging from my mailbag. Here are some of the frequently asked questions.

Can I contribute to an HSA once I'm retired? You can, so long as you're still enrolled in a high-deductible health-care plan. But once you've signed up for Medicare (Part A or Part B), you can no longer make HSA contributions.

HSA owners who are older than age 55 can make an additional catch-up contribution of $1,000, making the total 2017 contribution limit for people over 55 $4,400 for individuals or $7,750 for people who have a family plan.

Are distributions from my HSA tax-free and penalty-free if I use them for health expenses of someone else, such as a parent, sibling, or friend? You can take penalty- and tax-free distributions from your HSA only if you're using the money for yourself, your spouse, or someone you have claimed or could claim as a dependent on your tax return.

One wrinkle is that even though the Affordable Care Act requires health-care plans to extend coverage to children under age 26, and therefore such children may be covered under high-deductible plans, withdrawals from the HSA will not be tax- and penalty-free unless that child can also be claimed as a dependent on your tax return. Say, for example, a 25-year-old son is covered under his father's high-deductible plan; that child is employed, providing most of his own support, and cannot be claimed as a dependent on his father's tax return. Because the son doesn't fit the Internal Revenue Service's definition of a dependent child, the father's HSA proceeds cannot be used for the son. Instead, the son would need to establish his own HSA.

Does it make sense to use my HSA exclusively as a tax-sheltered investment? That is: do not pay current health expenses using HSA; instead, pay such expenses with post-tax money, and maximize the amount I save in the HSA for future use after it has grown tax-free. What do you think? Although it might seem intuitively appealing to use your HSA to cover out-of-pocket health-care costs as you incur them (after all, that's ostensibly the purpose of the account), I think the strategy of delaying withdrawals is a terrific one for those who can afford to do so.

Look at it this way: Your HSA, though it carries restrictions on what the money can be used for, carries more generous tax benefits than any other tax-sheltered wrapper. And as with any tax-sheltered wrapper, the tax-saving benefits compound the longer you leave the money in that account.

By contrast, your taxable account--the alternative for paying out-of-pocket health-care costs--carries no such benefits. You put aftertax money into it, you may owe taxes on a year-to-year basis as your investments make income or capital gains distributions, and you're taxed on any appreciation at the time you withdraw your money.

Is there a risk of being left with too large of an HSA kitty later in life? I don't think so. The average retired couple can expect to spend $260,000 on out-of-pocket health-care costs during retirement, according to a recent study from Fidelity.

And even if you're lucky and your health-care expenses are much lower than that, you can still use HSA proceeds for any other expenditures once you reach age 65. If you go that route, the tax treatment of nonqualified withdrawals coming out of your HSA will be similar to that of a 401(k): pretax assets going in, tax-deferred compounding, and taxable withdrawals.

Finally, you have quite a bit of latitude to take qualified distributions from your HSA later on, even if you didn't tap your account for health-care expenses as you incurred them but instead covered them out-of-pocket. So long as you've saved your receipts for the expenses you covered on your own, you can withdraw an amount matching your receipts in future years, and those withdrawals will be tax- and penalty-free. You can reimburse yourself for qualified health-care expenses from your HSA even years later; there's no time limit.

What happens to assets left behind in an HSA after I die? You can and should name a beneficiary for your HSA just as you can for any other account type. If your spouse inherits your HSA, the account becomes his or her HSA and is subject to the same rules governing any other HSA. If someone other than your spouse inherits the HSA assets, the HSA assets are includible in that individual's gross income; the HSA ceases to exist.

I'm self-employed and contributing to an HSA. Can I make pretax contributions? No. The mechanics of your contributions will be slightly different than if you were covered by an HDHP and contributing to an HSA offered by your employer. Self-employed individuals must contribute aftertax dollars to their HSAs and then take a deduction on their tax returns. All individuals contributing to HSAs must also file IRS form 8889, which details HSA contributions and withdrawals.

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