41.12 Distributions From HSAs

Distributions from an HSA used exclusively to pay or reimburse qualified medical expenses of the account owner, his or her spouse, or dependents are not taxable. Distributions used for anything other than qualified medical expenses are taxable. Taxable distributions are also subject to a 20% penalty unless the distribution is made after the account owner becomes disabled, reaches age 65, or dies.

Caution

IRS Can Levy on HSAs

The IRS can levy on an HSA to recover taxed owed. If the HSA owner is under age 65, there is a 20% penalty (there is no exception from this penalty for an involuntary distribution such as an IRS levy).

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Distributions need not be taken in the year in which the expense is incurred to be tax free; they can be taken in the following year or in any later year. This may be necessary if there are insufficient funds to cover the expense at the time it is incurred. For example, an HSA account holder who incurs a $1,500 medical expense on December 1, 2012, can wait until 2013 (or later) when the account balance exceeds $1,500. The distribution is tax free so long as records are kept to show that the distribution was used to reimburse qualified medical expenses that were not covered by insurance or otherwise reimbursed and not claimed in a prior year as an itemized deduction. The HSA must have been set up prior to the incurrence of the expense.

For tax-free distribution purposes, a “qualified medical expense” is generally a non-reimbursed payment for medical care that would otherwise be eligible for an itemized deduction (17.2). Qualified medical expenses also include over-the-counter medications with a doctor’s prescription. However, health-care premiums generally do not qualify for HSA purposes, but there are exceptions. An HSA can pay for premiums for long-term-care insurance, COBRA health-care continuation coverage, health coverage while an individual is receiving unemployment compensation, and for individuals over age 65, Medicare Part A, B, or D, Medicare HMO, and the employee share of premiums for employer-sponsored health insurance including retiree health insurance. HSA distributions used to pay or reimburse long-term-care premiums are tax free only to the extent of the age-based deductible limit for such premiums (17.5). For example, if a person age 41 uses HSA funds to pay long-term-care premiums of $1,800 in 2012, only $660 (the deductible limit for those age 41 through 50 in 2012) is tax free. The balance is taxable and subject to a 20% penalty for withdrawal of funds prior to age 65.

A qualified medical expense may be for the care of the account owner, his or her spouse, or dependents, without regard to whether they are eligible to make HSA contributions. In the case of a married couple where both spouses have HSAs, one spouse may use a distribution from his or her HSA to pay or reimburse the qualified medical costs of the other spouse. However, both HSAs may not reimburse the same expense.

If an HSA account holder mistakenly takes a distribution such as to reimburse an expense he or she reasonably but mistakenly believes is a qualified medical expense, the funds can be repaid to the HSA in order to avoid tax on the withdrawn amount, assuming the plan accepts a return of mistaken distributions. The funds must be returned by April 15 of the year following the first year that the account holder knew or should have known of the mistake.

Inherited HSAs.

If the beneficiary of an HSA is the surviving spouse of the deceased account owner, the surviving spouse becomes the owner of the account and will be subject to tax only on distributions that are not used for qualified medical expenses. If the beneficiary is not the surviving spouse, the account ceases to be an HSA as of the date of the owner’s death and the date-of-death value of the HSA assets must be included in the beneficiary’s income. The beneficiary (other than the decedent’s estate) may reduce the taxable amount by any HSA payments for the decedent’s medical expenses made within one year after death. A beneficiary is not subject to the penalty for taxable distributions.

Report HSA distributions on Form 8889.

You must report an HSA distribution on Part II of Form 8889, which must be attached to Form 1040. A taxable distribution, if any, from Form 8889 is reported on Line 21 of Form 1040 (“Other income”). On the dotted line next to Line 21 enter “HSA” and the amount. If there is a taxable distribution and no exception to the penalty is available, the 20% penalty is entered on Form 8889 and reported on Line 60 of Form 1040. On the dotted line next to Line 60, enter “HSA” and the amount. The HSA custodian or trustee will report the distribution to the IRS on Form 1099-SA.