Contributions to HSAs

Contributions to a health savings account (HSA) can be made by or on behalf of (for example, by a family member) any eligible individual and are deductible by the eligible individual "above the line" in arriving at adjusted gross income (AGI) (Sec. 62(a)(19)). Thus, eligible individuals can benefit regardless of whether they itemize deductions. However, the individual cannot also deduct the contributions as a medical expense under Sec. 213 (Sec. 223(f)(6)), and the deduction will not reduce a self-employed person's self-employment tax. Also, contributions can be made by or on behalf of an eligible individual even if the individual has no compensation or if the contributions exceed his or her compensation.

Observation: Deductible HSA contributions can be used to offset all forms of income including interest, dividends, retirement plan income, capital gains, and other items.

The maximum annual contribution to an HSA is the sum of the limits determined separately for each month, based on status, eligibility, and health plan coverage as of the first day of the month (Sec. 223(b)(1)). For 2017, the maximum monthly contribution for eligible individuals is one-twelfth of $3,400 for single coverage or $6,750 for family coverage (Sec. 223(b)(2); Rev. Proc. 2016-28). Also, HSA contribution eligibility is based on the individual's eligibility status as of the first day of the last month of the year. Therefore, if the taxpayer establishes the HSA in the middle of the year (and is still eligible on the first day of December), he or she will be treated as eligible during each of the months in the tax year and as having been enrolled in the same high-deductible health plan (HDHP) that currently qualifies him or her for an HSA (Sec. 223(b)(8)(A)). However, if the taxpayer ceases to be eligible (except by reason of death or disability) for an HSA during a testing period that begins on the first day of the last month of the year the taxpayer becomes eligible and ends on the last day of the 12th month following that month (i.e., Dec. 1 of current year through Dec. 31 of following year), he or she must recapture the amount contributed for the period he or she was ineligible, as income, plus pay a 10% penalty tax (Sec. 223(b)(8)(B)).

It is not necessary to distribute this amount from the HSA, and earnings on this amount are not included in gross income or subject to the additional 10% penalty tax as long as the earnings remain in the HSA or are used for qualified medical expenses. This amount is also not considered an excess contribution to the HSA and is therefore not subject to the Sec. 4973 6% excise tax for excess contributions to HSAs. However, if an individual who fails the testing period leaves the recaptured funds in the HSA and later makes a nonqualified HSA distribution (one that is not used for qualified medical expenses), the distribution is taxable and subject to penalty without regard to the previous inclusion in income and penalty (Notice 2008-52).

Example 1: W is a self-employed sole proprietor. He begins self-only coverage under an HDHP on Aug. 1, 2017, and continues to be covered throughout the remainder of the year. He continues this coverage beyond Dec. 31, 2018. The annual deductible is $4,000 under the plan. For 2017, W can contribute (and deduct) a maximum amount of $3,400 to an HSA.

Example 2: Assume the same facts as Example 1 and that W accepts a new position with Z Inc. in June 2018. Z Inc. provides comprehensive medical coverage as part of its compensation package. Since W ceased being an eligible individual prior to Dec. 31, 2018, he must report $1,983 ($3,400 × [7 ÷ 12] related to January-July 2017) recapture income on his 2018 return, plus pay $198 ($1,983 × 10%) in penalty tax.

All HSA contributions made by or on behalf of an eligible individual are aggregated for purposes of applying the limit (Sec. 223(a)). The same annual contribution limit applies whether an employee, an employer, a self-employed person, or a family member makes the contributions (Notice 2004-2). (Family members may make contributions to an HSA on behalf of another family member as long as that other family member is an eligible individual.) The annual limit is also decreased by the aggregate contributions to a medical savings account (MSA) (Sec. 223(b)(4)(A)). Contributions may be made by or on behalf of eligible individuals even if the individuals have no compensation or if the contributions exceed their compensation. For an individual with more than one HSA, the aggregate annual contributions to all HSAs are subject to the limit.

A participant (and his or her spouse covered under an HDHP) who is 55 or older as of the end of the tax year for which an HSA contribution is made is allowed to make a larger deductible contribution. Specifically, the annual contribution limit that would otherwise apply is increased by $1,000 (Sec. 223(b)(3)). However, the participant loses the right to make HSA contributions when he or she becomes eligible (under current law, at age 65) and actually enrolls in Medicare (Sec. 223(b)(7), Notices 2004-50 and 2008-59).

Example 3: A has family health insurance coverage with a $3,000 deductible. If she will be 55 or older on Dec. 31, 2017, she can contribute up to $7,750 to her HSA for 2017 (the normal $6,750 limitation + $1,000 extra due to her age). If A's family policy covers her spouse and he is also 55 or older as of Dec. 31, 2017, A can still contribute $7,750 to her HSA (the normal $6,750 limitation + $1,000 extra due to her age), and her spouse can contribute $1,000 (catch-up contribution) to his own HSA (Notice 2008-59, Q&A 22).

Example 4: Assume the same facts as in Example 3, except that A is not married and attains age 65, becoming eligible for Medicare benefits, in July 2017. She immediately enrolls in Medicare. She cannot make HSA contributions (including catch-up contributions) after June 2017. A can make total contributions for 2017 (January through June) equal to $3,875 (($6,750 × [6 ÷ 12]) + ($1,000 × [6 ÷ 12])).

If either an individual or the individual's spouse has family coverage, both are considered to have family coverage. Likewise, if one spouse has self-only coverage and the other has family coverage, the maximum contribution limit is the maximum for family coverage, and the limit is divided between them by agreement (Notice 2008-59, Q&A 17). If the spouses have different family coverage plans, only the one with the lower deductible is counted for HSA eligibility purposes (Sec. 223(b)(5)).

The family contribution amount can be allocated between eligible spouses any way they want but must be divided equally among the spouses if they do not agree on a different division. However, no HSA contribution is allowed for an ineligible spouse. The IRS has ruled that an eligible individual does not fail to be an eligible individual merely because the individual's spouse has non-HDHP family coverage, if the spouse's non-HDHP does not cover the individual. Consequently, that individual may contribute to an HSA (Rev. Rul. 2005-25). The following two examples illustrate how the HSA contribution limitation rules work in this scenario.

Example 5: T and N are married. Both are under age 55. For all of 2017, T has self-only coverage under an HDHP with a $2,000 annual deductible. He has no other health coverage. N has non-HDHP family coverage for herself and the couple's two dependent children. T is not covered by N's non-HDHP. Because he has no health coverage beyond his own HDHP, T is eligible to contribute up to $3,400 to an HSA for the 2017 tax year (the maximum contribution amount for self-only coverage for 2017). Since N is under non-HDHP coverage, she is ineligible to make an HSA contribution for 2017.

Example 6: Assume the same facts as in Example 5, except that T has HDHP family coverage for all of 2017 for himself and one of the dependent children. The HDHP has an annual deductible of $5,000. N has non-HDHP family coverage for herself and the other dependent child. Once again, T has no other health coverage and is not covered by N's non-HDHP. Because he has no health coverage beyond his own HDHP, T can contribute up to $6,750 to an HSA for the 2017 tax year (the maximum for family coverage for 2017). N has non-HDHP coverage and is therefore ineligible to make an HSA contribution for 2017.

Example 7: D, age 58, and M, age 53, are married. Both have family coverage under separate HDHPs. D's HDHP has a $3,000 deductible, and M's has a $2,600 deductible. D and M are treated as covered under the plan with the $2,600 deductible and, therefore, meet the minimum $2,600 deductible requirement for a family coverage HDHP. For 2017, D can contribute $4,375 to his HSA (half of the family coverage limit of $6,750 + the entire $1,000 catch-up contribution), and M can contribute $3,375 to her HSA (unless they agree on a different division).

Employers are permitted (but are not required) to make deductible contributions to HSAs set up for their employees—subject to the same dollar limits and eligibility rules previously discussed. The employee cannot deduct employer contributions on his or her federal income tax return. Instead, employer-funded HSA contributions are exempt from federal income, Social Security, Medicare, and Federal Unemployment Tax Act (FUTA) taxes because they are considered to be for an employer-provided accident or health plan (Sec. 106(d)). However, the employer may be subject to a 35% excise tax (35% of the employer's total HSA contributions for the year) if comparable contributions are not made for all employees who have comparable coverage during the same period. For this purpose, comparable contribution means the same amount or the same percentage of the health insurance deductible for all employees within the same category of HDHP coverage. For this purpose, there are two HDHP coverage categories: (1) self-only coverage and (2) family coverage, which means anything other than self-only coverage. In general, HSA contributions can be made for employees in only one coverage category or the other without violating the comparability rules. More generous contributions can be made for employees in one category while less generous or no contributions are made for employees in the other category. However, the employer can also offer the following self-plus family coverage options: (1) self plus one; (2) self plus two; and (3) self plus three or more. In this scenario, special rules apply. Each option can be treated as a separate coverage category. But contributions for self-plus-two coverage must at least equal contributions for self plus one, and contributions for self-plus-three or more coverage must at least equal contributions for self plus two. Also, all family coverage options that cover the same number of people must be treated as being in the same self-plus-family coverage category. For example, self plus spouse and self plus one dependent both fall into the self-plus-one category.

Under the regulations, three employee categories also exist: (1) current full-time workers (those who work 30 or more hours per week); (2) current part-time workers (those who work fewer than 30 hours per week); and (3) former employees (this category, however, does not include former employees with continued HDHP coverage under the COBRA rules). The comparability rules are generally applied separately to each category. Again, more generous contributions can be made for employees in one category while less generous or no contributions are made for employees in the other categories (see Regs. Secs. 54.4980G-1 through -5).

Note: The regulations create the term comparable participating employees when referring to these comparability rules. This means all employees who are (1) eligible for HSA contributions under the general contribution rules, (2) in the same HDHP coverage category (self only, family, or self plus family), and (3) in the same employee category (current full-time, current part-time, or former). Therefore, an employer could have many groups of comparable participating employees. The employer is generally allowed to have a different HSA funding policy for each group, as long as the contributions (if any) for each group meet the fundamental comparability rule.

Example 8:  For the current year, C Co. makes equal $1,000 contributions for all employees who are eligible for HSA contributions and who have self-only HDHP coverage. It also makes equal $2,000 contributions for all eligible employees with family HDHP coverage. No contributions are made for part-time or former employees. These contributions pass the comparability test even though a larger dollar amount is contributed for employees with family coverage and no contributions are made for part-time or former employees.

Note: Regs. Sec.54.4980G-4 provides a means for employers to comply with the comparability requirements for employees that either have not established an HSA by Dec. 31, or that may have established an HSA but not notified their employer. Practitioners with clients in those situations should review the regulation for the proper contribution requirement and notice requirement. See also Regs. Sec.54.4980G-4 for rules regarding comparable contributions for part-year eligible employees.

Highly compensated employees (HCEs) may be treated as a separate class from non-HCEs as long as larger HSA contributions are made for the non-HCEs (Sec. 4980G(d)). Thus, comparable contributions can be made to all eligible non-HCEs without making any contributions to the HSA of any HCE. An HCE is anyone who (1) was a more-than-5% owner at any time during the year or preceding year or (2) for the preceding year received compensation in excess of $120,000 (for plan years beginning in 2017) and, if the company so elected, was in the top 20% of employees when ranked by pay (Sec. 414(q); Notice 2016-62).

In general, employees who have HDHP coverage provided by an employer and those with HDHP coverage from outside sources are not considered to be comparable participating employees. Therefore, the comparability rules allow the employer to limit HSA contributions to only those employees eligible for HSA contributions based on HDHP coverage provided by that employer. No contributions are required for those who do not have HDHP coverage from that employer. However, if the employer chooses to make contributions only for employees with HDHP coverage from that employer, comparable contributions must be made for all comparable participating employees with such coverage. And, if the employer chooses to make contributions for all eligible employees regardless of the source of their HDHP coverage, the employer must make comparable contributions for all comparable participating employees, regardless of whether they have HDHP coverage from that employer or coverage from an outside source (Regs. Sec.54.4980G-3).

The previously mentioned comparability rules do not apply to HSA contributions made through salary reduction contributions under a Sec. 125 cafeteria plan. The separate Sec. 125 nondiscrimination rules apply to this situation (Regs. Sec.54.4980G-5).

Observation: The HSA concept is intended to (1) encourage employers that do not currently provide any health coverage to obtain high-deductible group insurance and (2) encourage employers that may be considering dropping health coverage to instead consider the alternative of arranging for cheaper high-deductible insurance. However, some closely held corporations are likely to make HSA contributions on behalf of their shareholder-employees and other employees who are related to the owners (assuming the comparable-contribution test can be passed). When feasible, employer HSA contributions are quite beneficial because they are deductible by the employer and exempt from federal income and employment taxes.

Contributions by individuals to an HSA, or if made on behalf of an individual to an HSA, are not deductible to the extent they exceed the previously discussed limits. Contributions by an employer to an HSA for an employee are included in the gross income of the employee to the extent they exceed the limits or if they are made on behalf of an employee who is not an eligible individual. In addition, an excise tax of 6% for each tax year is imposed on the participant (the individual on whose behalf the HSA was established) for excess individual and employer contributions (Notice 2004-50).

If the excess contribution for a tax year and the net income attributable to such excess contribution are paid to the participant (withdrawn by the participant) before the due date (including extensions) for filing the account participant's federal income tax return for the tax year, then the net income attributable to the excess contribution is included in the participant's gross income for the tax year in which the distribution is received, but the excise tax is not imposed and the distribution of the excess contribution is not taxed (Sec. 223(f)(3)).

Example 9: J is 45 and has self-only coverage under an HDHP. He established an HSA on Jan. 1, 2017, and contributed $4,100 to the HSA for 2017. The deductible under the plan is $5,000. His contribution limit for 2017 was $3,400, and he has an excess contribution of $700. If J withdraws the $700 from the HSA and the earnings attributable to that $700 before the due date including extensions of his federal income tax return for 2017, only the earnings attributable to the $700 will be includible in his gross income for the year in which he receives the withdrawal (taxable in 2018 if he withdraws the proper amount in 2018). The excess contribution is not taxed, nor is there any excise tax imposed for the excess contribution.

Contributions to an HSA must be made in the form of cash; stock or other property is not allowable (Sec. 223(d)(1)(A)(i)). Contributions for the tax year can be made in one or more payments, at the convenience of the individual or the employer, at any time before the due date (without extensions) for filing the eligible individual's federal income tax return for that year (generally April 15 following the year for which the contribution is made), but not before the beginning of that year (Sec. 223(d)(4)(B), by reference to Sec. 219(f)(3)). Although the annual contribution is determined monthly, the maximum contribution may be made on the first day of the year (Notice 2004-2, Q&A 21).

Rollover contributions from MSAs and other HSAs into an HSA are permitted at any time. A rollover from an HSA to another HSA of the same participant must be completed within 60 days after the day on which the participant receives the payment or distribution, and only one rollover from an HSA to another HSA is allowed within a one-year period ending on the day of such receipt (Sec. 223(f)(5)).

A taxpayer may make one tax-free rollover from a traditional or Roth IRA (that would be otherwise taxable when distributed) to an HSA (Sec. 408(d)(9)(A)). The rollover contribution from an IRA may not exceed the taxpayer's maximum HSA contribution for the year (Sec. 408(d)(9)(C)(i)) and is also not subject to the Sec. 72(t) 10% early distribution penalty tax (Notice 2008-51). The rollover must be made directly to the HSA by the IRA trustee (Sec. 408(d)(9)(B)). The taxpayer must remain eligible for an HSA until the last day of the 12th month following the rollover or the distribution will be includible in income and subject to a 10% penalty tax unless the failure is due to death or disability (Sec. 408(d)(9)(D)). Rollover contributions are nondeductible. IRA rollover contributions reduce an individual's deductible HSA contribution maximum for the year of the rollover (Notice 2008-51).

This case study has been adapted from PPC's Guide to Tax Planning for High Income Individuals, 18th ed. (March 2017), by Anthony J. DeChellis and Patrick L. Young. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2016 (800-431-9025; tax.thomsonreuters.com).