At CMP, we work with clients every day to help them save money on their tax bills and take advantage of savings. With that in mind, here is what you should know about how an HSA tax deduction can help you lower your taxes.
What is a Health Savings Account?
A Health Savings Account or HSA is an account created by the Medicare Prescription Drug, Improvement, and Modernization Act, which was signed into law by then-President George W. Bush in December of 2003. HSAs were designed to allow participants to set aside tax-free money to pay for qualifying medical expenses. HSAs are typically administered by a financial institution such as a credit union or bank or by an insurance company, thus allowing the account owner to do several things at the same time:
- Save money for future medical expenses on a tax-free basis.
- Earn interest in their contributions.
- Avoid accruing medical debt.
- Reduce taxable income.
- Save money on their income taxes.
The tax-free money in your HSA can be used for a variety of expenses, including your co-pays, deductibles, prescription drugs, emergency room visits, and other medical expenses. It may not be used to pay your insurance premiums.
Unlike flexible spending accounts, HSA contributions may be made by employers or by individuals to pay for qualifying medical expenses. You are not required to pay regular income tax on HSA contributions or on the interest you earn on your HSA savings.
HSAs are not available to everybody. We will talk more about qualifications in the next section, but HSAs are designed to help people with high deductible health plans (HDHPs) afford preventive and other medical expenses.
HSA Qualifying Rules and Limitations on Contributions
As we noted above, Health Savings Accounts are not open to everybody. Here are the requirements you should know about to see if you qualify for an HSA account.
- The person who owns the HSA account must be 18 years of age or older.
- The person who owns the HSA account must be continuously covered by a high-deductible health plan. The definition of a "high deductible health plan" changes each year under IRS rules. For 2022, the deductible requirement is $1,400 for individual coverage and $2,800 for family coverage. We’ll talk later about some changes put into place by the passage of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) in response to the COVID-19 pandemic.
- The annual out-of-pocket expenses, which include co-payments, deductibles, and other amounts and exclude premiums, do not exceed $7,000 for individual coverage or $14,000 for family coverage.
In terms of contributing to an HSA, there are annual contribution limits you should know about, as well. For 2022, the IRS has set the annual contribution limits for HSAs as follows:
- A maximum HSA contribution limit of $3,650 for individuals with self-only coverage; and
- A maximum HSA contribution limit of $7,300 for individuals with family coverage.
- HSA owners over the age of 55 may make an additional catch-up contribution of $1,000 per year.
Any excess contribution remaining in your HSA at the end of the year will automatically roll over into the next year, making it an ideal choice if you have concerns about being able to afford necessary medical treatments. Remember, contributions are made on a pre-tax basis, and withdrawals are tax-free. We'll talk more about that in the next section.
How Does a Health Savings Account Affect My Taxes?
There are several key ways in which having an HSA can have a positive impact on your taxes. Here are some of the things you can expect.
First, the entire contribution you make to your HSA is tax-deductible if you contribute directly to the HSA. The deduction for your HSA will reduce your adjusted gross income and may move you into a lower tax bracket, thus reducing your tax bill for the year.
If you fund your HSA via employer contributions using payroll deductions from your gross income, then you may not deduct the amount on your taxes because your employer will have done it. However, you will still need to report it along with any disbursements you receive from your HSA. The deduction and resultant tax savings may mean that when you file your tax return, you get a refund when you otherwise wouldn't or that your refund will be larger than it would have been without the HSA contribution.
Another nice tax-related benefit of opening and funding an HSA up to the contribution limits is that any interest you earn on the funds in your HSA is not taxable. You can roll the interest over to the following year along with any contributions you didn’t use to pay for qualified medical expenses in the following year(s).
The other tax-related issue you should know about is that even though HSA contributions are either made pre-tax by your employer or deductible on your taxes, withdrawals of HSA funds are tax-free if you use them for qualified medical expenses. These may include your deductibles, co-pay amounts, medical expenses, and expenses for over-the-counter medications and health supplies.
Finally, after you reach the age of 65, you may take distributions from your HSA and use them for non-medical expenses without being taxed or penalized.
Reporting Your Health Saving Account on Your Taxes
Whether your employer makes HSA contributions on your behalf or you make them directly, you must report the HSA and all HSA contributions and disbursements to the Internal Revenue Service (IRS) using Form 8889. You may also use Form 8889 to calculate the amounts you must include in your reported income and to determine your HSA eligibility. If you are not eligible, then your contributions will not be tax-deductible.
Here are some important things to keep in mind when you complete Form 8889:
- If you started the year with an individual HDHP and transitioned to a family plan or vice versa, you must check the box that corresponds with the plan that you had for most of the year. In other words, if you had an individual plan for 8 months and then got married and transitioned to a family plan, you would check the individual box on the form.
- Using the above example, your annual contributions and deductions would be determined based on the HDHP coverage you had on the first day of the last month of the year. For example, if you switched to a family HDHP in November, you would be eligible to contribute up to $7,200 for the year plus the $1,000 catch-up contribution if you are over the age of 55. Likewise, you would be eligible for the tax break associated with a family account.
- If you started an HSA in November of a given year, you would be eligible to make HSA contributions up to the annual limit and claim all related tax deductions and benefits. The same rule applies as noted above if you switched from an individual to a family plan.
The rules for reporting HSA contributions and disbursements are simple to understand, and they shouldn't complicate your income tax return. The HSA deduction can help you reduce your regular income tax burden and make it easier to pay your qualified expenses.
How to Calculate HSA Tax Deduction
While it's not complicated to calculate your HSA deduction, we want to walk you through the process. This way, you can be sure to file your income tax return properly and get your tax refund, if you are due to receive one, as quickly as possible. Here are the steps to follow, and you can see Form 8889 and instructions for additional information.
- Choose your plan (individual or family).
- Enter the total amount of HSA contributions made by you or on your behalf, excluding employer contributions. You should receive Form 5498-SA from your bank or whichever institution administers your HSA.
- Enter the standard deduction for an individual or family plan.
- Add additional catch-up contributions you made, if applicable.
- Subtract your Archer MSA contributions, if applicable.
- Add your employer contributions and any distributions from your HSA savings. Distributions should be reported to you on Form 1099-SA.
- Subtract the total in #6 from your total contributions.
- Enter your total contributions or the total adjusted contributions, whichever is smaller, and enter that line as your deduction.
Some circumstances may be more complex, in which case you can get the help of a tax professional to calculate your deduction.
How to Claim HSA Tax Deduction
Many of our clients ask us how to claim HSA contributions on taxes. After you calculate the eligible deduction for your HSA account, the next step is to claim the appropriate deduction on your annual federal tax return. You will need to file Form 1040 and attach IRS Schedule 1 to report your HSA contributions and take the appropriate tax deduction.
To claim the deduction, you will enter the amount you calculated using Form 8889 on Line 12 of Schedule 1. You can also use Schedule 1 to calculate other deductions, including alimony, farm income, and business losses. You will enter the total on Line 22 of Schedule 1 on Line 10a of your 1040 Form.
How the CARES Act Affects HSA
The CARES Act became law in 2020 and was designed to provide financial assistance to people affected by the COVID-19 pandemic. Some relevant changes to the HSA rules included the following:
- Remote care coverage and telehealth with plan years beginning before 2022 are disregarded in determining eligibility to contribute to an HSA.
- Any HDHP year beginning before 2022 may include a $0 deductible for telehealth and remote care services.
- Over-the-counter medicine, whether it is prescribed or not, and menstrual care products are treated as medical care for amounts paid in 2019 or later for HSA spending.
Since many individuals and families relied on remote and telehealth during the pandemic, the decision was made to relax the standards for both HDHP coverage and HSA spending to allow people to access the funds when necessary.
Let Our Tax Professionals Help You Use HSA as a Tax Planning Strategy
Opening and funding a health savings account (HSA) can be a cost-effective way to save money for both medical expenses for you and your family and some money every tax year by reducing your taxable income and reducing your tax burden. Because the money rolls over and may be disbursed tax-free after you reach the age of 65, unused funds may also help you have a comfortable retirement.
Do you need help determining your HSA tax benefits? Contact our income tax advisors. We're here to help!