Health savings accounts (HSAs) have become popular for many employees seeking to efficiently manage their healthcare expenses. HSAs empower you to save for current and future medical costs by offering a unique blend of tax advantages and flexibility. However, navigating the complexities of HSAs, particularly distributions, can sometimes lead to unintended errors.

This article highlights HSA distributions and how to correct common mistakes.

Understanding HSAs

HSAs are tax-advantaged savings accounts available to individuals enrolled in high-deductible health plans (HDHPs). These accounts allow participants to set aside pre-tax dollars to cover qualified medical expenses, such as doctor visits, prescriptions, and certain medical procedures. Unlike flexible spending accounts, funds in HSAs roll over from year to year and accumulate tax-free interest, making them a powerful tool for long-term health care planning.

Contributions to HSAs can come from both employees and employers. HSAs are subject to individual and family coverage annual contribution limits determined by the IRS. Keep in mind that if you roll HSA funds over from one account into another, those funds do not count towards the contribution limit.

Distributions from HSAs are tax-free if they’re used to pay for qualified medical expenses. However, if funds are withdrawn for nonqualified expenses before the age of 65, they are subject to both income tax and a 20% penalty. After age 65, nonqualified distributions are taxed as ordinary income but not subject to the additional penalty.

Correcting mistaken HSA distributions

Despite your best intentions, you may sometimes make errors when it comes to HSA distributions. HSAs come with a specific set of rules, deadlines, and potential penalties. The IRS allows you to correct “mistaken distributions.” You must have made the mistake due to a “reasonable cause” and have “clear and convincing” evidence to support that’s what happened. You must return the money no later than April 15 following the year you knew about or should have realized the mistake.

Common mistakes include using funds for nonqualified expenses, withdrawing funds, or depositing too much. Fortunately, you can take the following five steps to correct these errors and mitigate any potential penalties.

1. Identify and report the mistake. The first step in correcting a mistaken HSA distribution is identifying the error. Review your HSA transactions and ensure all distributions were used for qualified medical expenses. If you discover any nonqualified withdrawals, note the amount and the distribution date. It’s important to report the mistake after identifying it. After you report the mistake to the custodian, the custodian reports it to the IRS.
2. Reimburse the HSA. If you’ve mistakenly used HSA funds for nonqualified expenses, you must repay the distribution amount back into your HSA by the tax filing deadline for the year in which the distribution occurred. By reimbursing your HSA, you can avoid the income tax and the 20% penalty on nonqualified distributions.
3. Withdraw the excess contribution. If you’ve mistakenly contributed too much to your HSA, you can withdraw and handle the excess amount as taxable income for the year. Just make sure you withdraw before the due date of that year’s tax return and withdraw any income earned on the excess contribution (e.g., dividends and interest). If you don’t withdraw the amount before the tax deadline, you will still have to pay a 6% excise tax for that year. However, if you reduce your contribution by the same amount the following year, that excise tax won’t be applied to subsequent years.
4. Keep detailed records. To avoid future mistakes, keeping detailed records of your HSA transactions and expenses is crucial. Save receipts for all qualified medical expenses and maintain accurate contribution and distribution records. These HSA records will help you identify any errors and provide documentation in the event of an IRS audit.
5. Seek professional guidance. If you’re unsure how to correct a mistaken HSA distribution or navigate the complexities of HSA rules, don’t hesitate to seek professional guidance. A tax advisor or financial planner can provide personalized advice based on your situation and help you avoid pitfalls.

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Conclusion

HSAs offer significant benefits for saving and investing, such as tax advantages and flexibility for managing health care expenses. However, navigating these accounts’ rules and regulations can be challenging, and it’s essential to understand the rules governing distributions to avoid unintended consequences.

By understanding the basics of HSA distributions and taking proactive steps to correct any mistaken distributions, employees like you can maximize the benefits of their HSAs while avoiding costly penalties. Remember to keep detailed records, seek professional guidance when needed, and stay informed about changes to HSA rules and regulations to maximize this valuable savings tool.

Talk to your HR representative if you have any concerns or other benefits-related questions.

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This Know Your Benefits article is provided by Christensen Group Insurance and is to be used for informational purposes only and is not intended to replace the advice of an insurance professional. © 2024 Zywave, Inc. All rights reserved.