IRS Provides Guidance on Contributions to HSAs

The Tax Relief and Health Care Act of 2006, P.L. 109-432, made changes to the treatment of contributions to health savings accounts (HSAs) under Sec. 223. The IRS recently issued two notices explaining those changes. Notice 2008-52 provides general guidance on contributions to HSAs, and Notice 2008-51 provides guidance on the treatment of a one-time qualified funding distribution from an individual retirement account (IRA) or a Roth IRA to a health savings account.

Tax Treatment of HSAs

An HSA is a tax-advantaged medical savings account available to eligible individuals. Sec. 223(c)(1) defines eligible individuals as those who are covered by a high-deductible health plan (HDHP) and, with certain exceptions, not also covered by a health plan that is not high deductible. In addition, they may not be enrolled in Medicare (Sec. 223(b)(7)), and they may not be claimed as a dependent (Sec. 223(b)(6)).

Contributions to HSAs are generally deductible in computing adjusted gross income, and distributions from HSAs are excludible from gross income as long as they are exclusively used to pay qualified medical expenses of the individual or, depending on the type of coverage, the individual’s spouse or dependents. Distributions not used for qualified medical expenses are included in gross income and are subject to an additional 10% tax (Sec. 223(f)). The 10% tax, however, does not apply to distributions to individuals after they reach age 65, become disabled, or die.

Contribution Limits

Notice 2008-52 identifies limits to the amount of allowable contributions an individual can make to an HSA annually. The maximum allowable HSA contribution is limited to the greater of (1) the annual contribution limit or (2) the sum of the monthly contribution limits. The annual contribution limit is based on the type of coverage (self only or family) and available catch-up contribution amounts. This limit is available only if the individual is eligible on the first day of the last month of the tax year (December 1 for calendaryear taxpayers).

The annual contribution limits are indexed. In 2008, the limits are $2,900 for a self-only HDHP and $5,800 for family coverage. In addition, for individuals who are age 55 or above on the last day of the year, a catch-up contribution is allowed. In 2008, the amount is $900. The maximum monthly contribution limits equal 1/12 of the annual contribution limit for both regular contributions and catch-up contributions. Thus, the 2008 monthly contribution limits are $483.33 ($5,800 ÷ 12) for months where there is family coverage, $241.67 for self-only coverage months, and $75 for catch-up contributions.

Not only is eligibility for the annual contribution limit determined on the first day of the last month of the tax year, but the annual contribution limit amount is also determined on that day. The amount of the contribution limit is based on the individual’s coverage (self only, family, or none at all) at that time. The individual’s eligibility and coverage at other times during the year are not considered.

Example 1: Individual P carries family coverage for all of December. Her allowable contribution to an HSA is $5,800, even though she had no coverage during the rest of the year. Her annual limit of $5,800 is greater than the sum of her monthly limits, $483 ($5,800 × 1 ÷ 12).

Testing Period

There is a testing period for individuals who can use the annual contribution limit (Sec. 223(b)(8)(B)). This is a period during which the individual must maintain eligibility for an HSA or be subject to additional tax. Eligibility during the testing period does not require that the individual maintain the same level of HDHP coverage (self only or family); it requires only that some coverage be maintained. The testing period begins on the first day of the last month of the tax year (the same day that eligibility for the annual limit is determined), and it ends on the last day of the twelfth month following that month—a 13-month period.

If an individual’s contribution is based on the annual contribution limit and that individual ceases to be eligible anytime during the testing period, he or she must include in gross income an amount equal to the excess of actual contributions to the HSA over the sum of his or her monthly contribution limits. In addition, the individual must also pay an additional 10% tax on those contributions included in gross income. The income inclusion and additional tax do not apply to those whose ineligibility results from disability or death.

Example 2: For 2008, individual Q is not eligible during January and February, he has self-only HDHP coverage from March through September, and he has family coverage from October through December. Since he has family coverage on December 1, he is eligible for a $5,800 annual contribution to his HSA, because that amount is more than $3,142 [($2,900 × 7 ÷ 12) + ($5,800 × 3 ÷ 12)], the sum of his monthly contribution limits.

Example 3: Individual Q (from Example 2) contributes $5,800 to his HSA during 2008 and maintains eligibility until September 2009, when eligibility is lost. Since eligibility is not maintained for the entire testing period, Q must include in gross income $2,658, the difference between the amount contributed ($5,800) and the contribution allowable using the monthly contribution limits ($3,142). Q must also pay a 10% penalty tax ($266) on the amount included.

Example 4: Individual R is age 57 at the end of 2008. She is not eligible during January, she has family HDHP coverage from February through August, and for September until the end of the year she has self-only coverage. In this instance, the annual limit of $3,800 ($2,900 + $900) (based on self-only coverage at December 1) is less than the sum of the monthly limits of $5,175 [($5,800 × 7 ÷ 12) + ($2,900 × 4 ÷ 12) + ($900 × 11 ÷ 12)]. Thus, the contribution limit for the year is $5,175.

Example 5: Individual R (from Example 4) contributes $5,175 to her HSA during 2008 and maintains eligibility until September 2009, when eligibility is lost. Since the actual contributions were less than or equal to the sum of the monthly contribution limits, no additional amount needs to be included in gross income, and there is no additional 10% tax.

Excess Contributions

Excess contributions are those made to an HSA that exceed the maximum allowable contribution for the year. Under Sec. 4973(a)(5), excess contributions for the year are subject to an additional 6% tax for each year they remain in the account and are not withdrawn or offset by reductions in later-year contributions. If the excess contributions and the income earned on them are withdrawn before the due date (with extensions) for the year’s tax return, however, then the 6% tax does not apply.

Amounts included in gross income because an individual does not maintain eligibility during the testing period are not considered excess contributions. As a result, the additional gross income and 10% tax (Sec. 223(b)(8)(B)) cannot be avoided by withdrawing such amounts. In addition, if such amounts are withdrawn and the withdrawals are not used to pay for qualified medical expenses, they are included in gross income and may be subject to the 10% tax on distributions not used to pay qualified medical expenses (Sec. 223(f)).

Example 6: Individual S is age 58 in 2008. He is not eligible for the period January through May. From June 1 until the end of December he held self-only coverage, and he contributes $4,000 to an HSA. His contribution limit for the year is $3,800, the greater of the annual limit of $3,800 ($2,900 + $900) or the sum of the monthly limits of $2,217 [($2,900 × 7 ÷ 12) + ($900 × 7 ÷ 12)].

Since S contributed more than the maximum allowable contribution, he is subject to a 6% tax on the $200. S can avoid the tax, however, if he withdraws the $200 and the earnings on the $200 before the tax return due date. In that event, the earnings on the $200 must be included in S’s gross income, and the net contribution to the HSA amounts to $3,800.

Example 7: The same facts apply to individual S (from Example 6), except that he loses HSA eligibility in May 2009 and withdraws (without paying medical expenses) the income that is reported as a result of the lost HSA eligibility.

His allowable contribution in 2008 is the same $3,800. Because of the lost eligibility during 2009, for that year S must include in gross income $1,583, an amount equal to the excess of his actual contributions ($3,800) over of the sum of the monthly limits ($2,217). He must also pay an additional 10% tax on that amount ($158). Since S takes a distribution without using the funds to pay qualified medical expenses, he must also include that distribution in gross income and pay a 10% tax on it. Thus, under Sec. 223(b)(8)(B), S must include $1,583 in gross income and pay 10% additional tax for failure to maintain eligibility during the testing period; in addition, under Sec. 223(f), S must include another $1,583 in gross income and pay 10% additional tax for withdrawing that amount without paying qualified medical expenses.

Tax Treatment of IRA Distributions

In general, distributions from traditional IRAs are included in gross income under Sec. 408. If the IRA balance includes nondeductible contributions, then a proportionate part of each distribution is excludible (Secs. 72 (e)(8), 408(d)). Qualified distributions from Roth IRAs are also excludible under Sec. 408A(d). Nonqualified distributions from Roth IRAs, however, are included in gross income only to the extent that earnings are distributed, and earnings must represent a proportionate part of each distribution.

Under Sec.72(t), if a distribution from an IRA or Roth IRA is made before the account owner is 59., a 10% additional tax also applies to the taxable amount. Numerous exceptions apply to the additional 10% tax. For example, there are exceptions for death, disability, first home purchases, and distributions that are annuitized over the owner’s life expectancy (for more on this, see Burilovich and Burilovich, “Substantially Equal Periodic Payments from an IRA,” 39 The Tax Adviser 670 (October 2008)). There is also an exception for distributions that provide the one-time funding of a contribution to an HSA.

One-Time IRA Distributions to Fund HSAs

Sec. 408(d)(9) provides that eligible individuals are allowed a one-time qualified HSA funding distribution from an IRA or Roth IRA to fund a contribution to an HSA. The contribution must be a direct transfer from the IRA or Roth IRA to the HSA, and distributions from ongoing SIMPLE or SEP IRAs do not qualify. The contribution counts against the individual’s annual maximum allowable contribution to the HSA, and it is not deductible. A qualified funding distribution from the individual’s IRA or Roth IRA is not included in the individual’s gross income.

For purposes of determining the basis of the remaining balance in the IRA account, however, Notice 2008-51 stipulates that distributions are treated as first coming from amounts that would be taxable if there were a total (nonqualifying) distribution of the IRA. Thus, the basis of an IRA is not reduced by the qualified HSA funding distribution until all other amounts have been distributed; when the basis of the IRA is reduced by the distribution, that basis reduction does not transfer to the HSA.

Example 8: Individual T owns a $2,000 IRA with a $200 basis. If she makes a $1,500 qualifying funding distribution, her remaining balance is $500, and her IRA basis is still $200.

Example 9: Individual T (from Example 8) has an original basis of $600 in her IRA. After the $1,500 distribution, both the balance and her basis in the IRA are $500, and $100 of the original basis disappears.

The amount of the distribution is limited to the individual’s maximum HSA annual contribution limit for the year, based on type of HDHP coverage (family or self only) at the time of the contribution and the individual’s age at the end of the year.

The one-time distribution, however, can become a two-time distribution. That occurs when an individual takes a distribution to fund a self-only plan and later in the same year converts coverage to a family plan and takes another distribution to fund a second contribution.

Example 10: Individual U turns 55 on August 1, 2008, and is eligible from April 1 until the end of the year. On April 1, U acquires a self-only HDHP and takes a qualifying HSA funding distribution from his IRA in the amount of $3,800 ($2,900 maximum annual contribution plus $900 catch-up contribution). If on November 1, 2008, U obtains a family HDHP, he is eligible to take another qualifying distribution of up to $2,900—for a total of $6,700 for the year. Because both transactions are qualified HSA funding distributions, no income is included from the IRA distributions, and no deduction is allowed for the contributions to the HSA.

Testing Period for One-Time HSA Funding Distributions

A testing period also applies to HSA contributions funded by one-time distributions from IRAs or Roth IRAs. There are, however, some important differences between the testing period for onetime HSA funding distributions (Sec. 408(d)(9)(D)) and the testing period for typical contributions to HSAs (Sec. 223(b)(8)). First, in the case of a qualified funding distribution, if the individual fails to remain an eligible individual for the entire testing period, the full amount of the distribution must be included in gross income in the year the individual fails to be an eligible individual. That amount is also subject to the additional 10% tax. If an individual is ineligible because he or she becomes disabled or dies, however, the income is not included and the 10% tax is not applied.

The second important difference is that for qualified HSA funding distributions, the testing period does not begin on the first day of the last month of the year of the contribution. Instead, it begins on the first day of the month in which the distribution is contributed to the HSA. The testing period ends on the last day of the twelfth month following that month—a 13-month period. If there is more than one qualified HSA funding distribution, each contribution to the HSA is subject to its own testing period.

Contributions to the HSA that are not qualified funding distributions may be subject to the regular testing period. Where an individual remains eligible for the testing period related to the qualified HSA funding distribution but does not remain eligible for the entire testing period related to the regular contributions, the amount that must be included in gross income and subject to the additional 10% tax is the lesser of:

1. The amount that would otherwise be included under the regular rules (Sec. 223(b)(8)(B)); or
2. The amount of contributions to the HSA for the year other than those contributed through qualified funding distributions.

Example 11: Individual V, age 47, is eligible from March 1, 2008, until August 31, 2009. On May 1, V purchases a family HDHP and contributes $5,000 to an HSA using a trustee-to-trustee transfer from his IRA. On December 1, V contributes an additional $800 cash to his HSA and deducts that amount. V has one qualified HSA funding distribution during the year, and he remains eligible during the entire testing period for that distribution. However, he fails to remain eligible for the entire testing period related to the regular contributions. The amount that must be included in gross income and subject to the additional 10% tax is $800, the lesser of the amount included under the regular rules of Sec. 223(b)(8)(B)—$967 [$5,800 – ($5,800 × 10 ÷ 12)]—or the amount of contributions to the HSA from sources other than qualified funding distributions—$ 800 ($5,800 – $5,000).

Example 12: Individual W, age 46, is eligible from March 1, 2008, until August 31, 2009. On April 1, 2008, W purchases a self-only HDHP and contributes $1,000 to an HSA using a trustee-to-trustee transfer from her IRA. On October 1, W converts to a family HDHP and contributes $1,200 to her HSA using a second qualified funding distribution from her IRA. On December 1, W contributes an additional $3,600 cash to her HSA and deducts that amount. While W has two qualified funding distributions during the year, she remains eligible during the entire testing period for only the first of those distributions.

In 2009, W must include a total of $3,858 in gross income and pay an additional 10% tax on that amount ($386). As a result of W’s failing to remain eligible for the testing period related to the second qualified funding distribution, $1,200 is included under Sec. 408(d)(9)(D). The remaining $2,658 is included under Sec. 223(b)(8)(D), the lesser of the amount included under the regular rules of Sec. 223(b)(8)(D)—$2,658 ($5,800 – [($2,900 × 7 ÷ 12) + ($5,800 × 3 ÷ 12)])—or the amount of contributions to the HSA from sources other than qualified funding distributions—$ 3,600 ($5,800 – $2,200).

Conclusion

While HSAs can be an effective tool for managing the costs associated with medical care, they are not without pitfalls. To maximize their usefulness, taxpayers need foresight and a clear plan for meeting their future health care needs.

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EditorNotes

Kevin F. Reilly, J.D., CPA, is a member of PKF Witt Mares in Fairfax, VA.

Unless otherwise noted, contributors are members of or associated with PKF North American Network.

For additional information about these items, contact Mr. Reilly at (703) 385-8809 or kreilly@pkfwittmares.com.