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What are the tax implications of health savings accounts (HSAs)?

By Janet Berry-Johnson

Many people are aware of the tax benefits of 401(k)s, IRAs and 529 plans, but if you're not taking advantage of a health savings account (HSA), you could be missing out on some serious tax benefits.

In this article, we’ll cover: 

1. What is an HSA?
2. How do you get an HSA?
3. What are the tax benefits of a HSA?
4. How do you report HSA distributions when filing your taxes?
5. Who might benefit from opening an HSA?
6. Common HSA mistakes

What is an HSA?

HSAs are special pre-tax accounts that allow you to pay for, or reimburse, out-of-pocket medical costs.

How do you get an HSA?

To qualify for an HSA, you must meet these requirements:

  • You must be insured under a high-deductible health plan (HDHP) that’s HSA-eligible. The IRS defines an HDHP as any plan with a deductible of at least $1,300 for an individual or $2,600 for a family.
  • You can’t be covered by Medicare or other health insurance (with certain exceptions such as dental, vision, long-term care, accident and disability coverage).
  • You can't be claimed as a dependent on someone else's tax return.

Although the Kaiser Family Foundation's 2016 Employer Health Benefits Survey found that the average deductible for single coverage is $1,478, few health insurance plans are HSA-eligible.

That's because the IRS specifies that except for preventive care, generally "an HDHP may not provide benefits for any year until the deductible for that year is satisfied."

So, a slightly more generous plan that pays for anything other than preventive care benefits before the deductible is met typically isn’t HSA-eligible.

Your employer or insurer may offer an HSA-eligible HDHP. In that case, they will usually recommend an HSA administrator. If you purchase an HSA-eligible HDHP on your own or don’t like the HSA administrator your employer uses, you can set up an HSA with any qualified trustee, such as a bank or insurance company.

What are the tax benefits of opening an HSA?

Generally, the tax advantages of contributing to an HSA are threefold.

First, if you make contributions through an employer's pretax plan (or your employer makes contributions on your behalf), those contributions are excluded from your gross income. In other words, you may avoid paying federal and state income tax and payroll taxes on those amounts.

If you make contributions to an HSA on your own, you can claim those contributions as an "above-the-line" deduction.

Donna Laubscher, CPA and a partner at Henry + Horne, LLP in Scottsdale, Arizona, says above-the-line deductions are "the most beneficial kind of tax deduction to have for an individual."

Because above-the-line deductions reduce your adjusted gross income (AGI), they can potentially also increase several other tax benefits that are phased out or disallowed altogether based on your AGI.

For example, education credits such as the American Opportunity credit are limited for taxpayers with adjusted gross income above $80,000 for single taxpayers ($160,000 for married filing jointly).

You don't have to itemize to take advantage of above-the-line deductions.

Secondly, funds in an HSA grow tax-deferred, meaning interest or other earnings on the amount in your account aren’t subject to tax.

Finally, distributions from an HSA are tax-free as long as they’re used for qualified medical expenses such as dental treatments, doctor copays, prescriptions and eye exams. You can find more detail on qualified medical expenses in IRS Publication 502.

How do you report HSA distributions on your taxes?

If you made contributions (or someone did on your behalf, such as your employer) to an HSA, you need to report these on Form 8889. You can’t file Form 8889 with the simpler Form 1040A or 1040EZ – you must submit it with Form 1040.

If you received a distribution from an HSA, you’ll receive a Form 1099-SA that will show how much you received in total from the HSA during the year.

If any distributions you received from your HSA weren’t used for qualified medical expenses, the excess will be taxed as income.

In addition, such amounts not used for qualified medical expenses may be subject to an additional 20 percent tax.

Who may benefit from opening an HSA?

Jason Lina, lead adviser with Resource Planning Group in Atlanta, says most individuals or families who are able to make the maximum HSA contributions can benefit from pairing an HDHP with an HSA, regardless of medical expenses.

HDHPs typically offer lower monthly premiums than other health insurance policies, because higher deductibles mean consumers are responsible for more health care costs.

And when you combine the monthly premium savings with the income tax benefits of contributing to an HSA, consumers can potentially save thousands of dollars over the course of a year.

However, Lina says, "For someone who can't afford to make the maximum HSA contribution, it's not as much as a sure thing." Laubscher also notes that low-income taxpayers may not benefit from contributing to an HSA. "Taxpayers that benefit the most are those that have a tax liability [the total amount of tax on your income]. If you’re in a lower tax bracket — the zero bracket, for example — there may not be as much immediate benefit."

Common HSA mistakes

Despite their growing popularity, some people make mistakes when it comes to HSAs.

First, you should never use the money in your HSA for nonmedical expenses, barring emergency circumstances.

"There’s a penalty that must be reported and paid on your tax return," Laubscher says. That penalty is 20 percent of the amount used for nonmedical purposes.

Nonqualified withdrawals are subject to income tax. If you’re age 65 or older, you can avoid the 20 percent penalty for nonqualified withdrawals, although the amount withdrawn will be subject to income taxes.

Generally speaking, paying for premiums with your HSA will also subject you to the 20 percent penalty, although there are several exceptions to this situation, such as payment for long-term care insurance.

Finally, if you can't make your HSA contribution before year end, don't think you're out of time. You have until April of the year following the tax year to make a contribution for the prior year. The IRS hasn’t yet provided the deadline in 2017 to make deductible HSA contributions for 2016. 

 

About the Author: Janet Berry-Johnson is a CPA and a freelance writer with a background in accounting and insurance. Her writing has appeared in Forbes, Freshbooks, The Penny Hoarder, Discover Student Loans, Chase News & Stories, Capitalist Review, Guyvorce and Intuit's Firm of the Future blog. Janet lives in Arizona with her husband and son and their rescue dog, Dexter.

Disclaimer: We know taxes are complicated, so we provide this information for general educational purposes only. It isn’t intended to be personalized legal, financial or tax advice, and we don’t guarantee the accuracy, completeness or reliability of this content. If you have questions about your personal tax situation, consider contacting an accountant, tax attorney or financial advisor. Come back to Credit Karma Tax when you’re ready to file your taxes for free!

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