Health Savings Accounts (HSA) are tax-favored IRA-type trust or custodial accounts that can be contributed to, by, or on behalf of “eligible individuals” who are covered by certain HDHPs (High Deductible Health Plans) to pay for certain medical expenses of the eligible individuals and their spouses and tax dependents. The statutory rules governing HSAs are found primarily in Code § 223, which was created as part of the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA). HSA Plans offer tax savings in three ways: tax-free contributions, investment growth, and distributions. HSAs can also be funded on a pre-tax basis through a Cafeteria Plan.
Only an individual that has qualifying HDHP coverage is considered eligible for an HSA so long as he or she does not have disqualifying non-HDHP coverage. If an employee is enrolled in either a full purpose FSA or HRA plan, they are not eligible to make contributions to an HSA. Tax dependents and those who are entitled to Medicare are also unable to participate in an HSA plan.
Employers may also contribute to their employees’ HSA account and take advantage of the tax savings. Employer contributions to an employee’s HSA are treated as employer-provided coverage for medical expenses under an accident or health plan, are excludable from an employee’s gross wages, and are not subject to FICA, FUTA, or RRTA taxes if the employer reasonably believes that the contributions will be excludable. The employer’s tax break is limited to the contributions that it makes to the HSA Plan of its employees who are HSA-eligible individuals. Once an employer makes a contribution to the employee’s HSA account that money stays with the employee’s HSA. In the event of termination of employment of an employee, funds already contributed to that employee’s HSA account cannot be returned to the employer. An employer wishing to make contributions to the employees’ HSA accounts should determine whether to contribute the amounts at a pro-rated amount each pay period or to contribute in one lump sum. Contributing on a pro-rated basis each pay period reduces the employer’s exposure.
Establishing an HSA is fairly easy. An individual may establish an HSA at any time on or after the date the individual becomes HSA eligible. An individual must find a qualified HSA trustee or custodian and complete and sign HSA trust or custodial agreement applications. An HSA trustee or custodian must be an insurance company as defined in Code § 816, a bank or similar financial institution as defined in Code § 408(n), or any other entity approved by the IRS, which includes any entity already approved as a trustee or custodian of IRAs.
Once an individual has established an HSA Plan, the next step is to determine the maximum amount that he or she can contribute and to decide when to make the contribution. The maximum annual HSA contribution amounts generally increase each year due to inflation. HSA account holders have a non-forfeitable interest in their account balances and generally may choose how to invest them. HSA funds may be invested in various vehicles approved for IRA investments (i.e. bank accounts, annuities, certificates of deposit, stocks, mutual funds, or bonds).
An HSA trustee or custodian is not required to determine whether HSA distributions are used for qualified medical expenses, and neither is a contributing employer. HSA account holders must make that determination and should maintain records of their medical expenses sufficient to show that the distributions that were not reported as taxable were made exclusively for qualified medical expenses. If a distribution is made from the HSA for an expense other than a qualified medical expense, the distribution is subject to an additional 10% excise tax.
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