Anytime our team of professional accountants at Baum CPA sees a ‘Code W’ on a W-2, this clues us in to the fact that the client has a HSA account. What is a HSA? Well, it’s a Health Savings Account — a special kind of investment account. If you are in a high-deductible health plan (HDHP) through the end of the year, you are entitled to have a HSA investment account. This is a way for Congress to say, “Gee, we’re sorry that we let you get ripped off by health insurance companies, so here is a consolation prize in the form of a tax-sheltered investment account — Your very own HSA.”
The concept is that in exchange for having such high health insurance premiums, the taxpayer can invest some extra money in a HSA to make an available reserve for out-of-pocket medical expenses.
Let’s Look at HSA from a Deeper Accounting Perspective
So… a HSA is basically an IRA that is used to pay medical expenses that health insurance benefits do not cover. Just like in The Hunger Games, if you survive the gauntlet of life and make it to the ripe old age of 65 without depleting the HSA, as soon as you enroll in Medicare, distributions from this account are not subject to penalty – even if they are not used for medical expenses. therefore, this account magically acts as another form of IRA that can be used for retirement (because at 65, all medical expenses get shifted to the collective taxpayers’ burden via Medicare). Also, just like The Hunger Games, few HSAs survive this long. Those distributions you make after 65 that are not used for medical expenses are subject to income tax – just like a traditional IRA.
A taxpayer can have an individual plan, or a family plan (if they have a family). For 2021, the contribution limit (from both employer and employee) is $3,600 for individuals, and double that for a family plan. If two married taxpayers each have a family plan, they still can only contribute $3,600 each. When a taxpayer’s employer makes a contribution, it is not a tax deduction to the taxpayer, but it does count towards these contribution limits. When a taxpayer is self-employed, it is entirely on them to make contributions — and these investments are fully deductible.
Whenever a client taxpayer has a HSA, we always review their IRS Form 8889, to see what their 8889 looked like on their prior year’s tax return. Part I relates to contributions, and Part II relates to distributions. Part III is the ugly part we don’t like to talk about — because it only comes into play if the client taxpayer failed to maintain their HSA plan. This is a serious matter that will cause even seasoned, veteran, case-hardened accountants (like the professional team here at Baum CPA!) to pray conspicuously to the tax gods: pray that we never have to consider Part III of the Form 8889.
If an employer makes a contribution, we’ll find out in box 12 of the W-2, with a — code W — (but WHY couldn’t they use Code H??? Logic seems to be sometimes against the law in IRS code and practice!). If there are any contributions (from either the employer or the employee), the taxpayer will receive a Form 5498-SA. Let’s say box 12 of the W-2 says “$1,000” but the 5498-SA says that total contributions were $2,000. This means that the taxpayer went above and beyond and made personal contributions to the HSA. Because of this, $1,000 is now tax deductible to the taxpayer. The HSA deduction reported should be $1,000.
If a taxpayer makes a distribution from a HSA, they receive a 1099-SA at the end of the year. If these distributions were used to pay reasonable medical expenses (including prescriptions, co-pays, etc.), then expenses paid from deposits made do not count as taxable income. If, however, they took a distribution so they can buy a brand new Xbox, then this expense does count as taxable income. This information gets reported on Part II of the Form 8889.
Some common HSA accounting errors we see self-prepared tax returns make:
- Treating an employer contribution as tax deductible.
- Treating a distribution used for medical expenses as taxable income.
If you choose to file your own tax return, make sure you review Form 8889 for accuracy. Otherwise, contact the experts at Baum CPA to file this for you. The first consultation is always FREE!
Let’s Look at a Deeper HSA Tax Strategy
If a taxpayer has a HSA and is in good health, they should maximize their contribution each year. We recommend they invest these funds into Exchange Traded Funds (ETFs) that focus on the broader stock market, and only use the HSA funds to pay for medical expenses when the amounts are significant and not practically affordable (think ER trips, surgeries, etc.).
“Why not pay a $100 prescription today with my HSA? The funds are just sitting there, and that is what they are intended for…,” asks the taxpayer. The answer to this is investment opportunity cost.
If $3,600 sits in a HSA account and earns the market rate of return averaging 10% per year over 30 years, the account balance will be $62,817.85 in 30 years — just from that first-year $3,600 deposit! If someone decides to charge that $100 medical expense against the HSA account today, that is a lost opportunity of roughly $1,750 in future dollars. A $15 co-pay today can cost the investor $260 tomorrow (or, in several tomorrows, but I’m going for dramatic effect now)! Keeping in mind The Hunger Games mentality — knowing that these dollars can act like IRA funds tomorrow — we often encourage our clients to leave the HSA funds alone for as long as possible — to the greatest extent possible.
The majority of Americans use their HSAs less-than-optimally by injecting the money pre-tax into the account, and immediately withdrawing it to pay for medical expenses. This is an absolute waste of the plan, as the plan is intended to accumulate wealth for future medical costs — not today’s minor medical expenses. Here’s some BIG MONEY food-for-thought (to quell that ‘Hunger’):
If you could just keep putting $3,600 year after year into your HSA, and somehow avoid drawing from it for that same 30 years, at age 65 it could easily be worth over $1,000,000 — yep, a cool million to add to your retirement portfolio!
If you can afford the expense, pay for your minor medical co-pays and over-the-counter supplies out of already-taxed net income — say, with your debit card — and watch that tax-deductible HSA fund grow!
I hope you enjoyed this unsolicited lesson on HSAs.
This blog and its authors provide this content strictly for informational purposes. No content herein should be misconstrued as financial advice. Everyone’s specific circumstances vary — Always consult with a qualified, licensed financial advisor, legal counsel, and tax professional before venturing into any investment or business activities.