The benefits of Health Savings Accounts for people who are eligible are tremendous. You get to make pre-tax contributions; you get to withdraw money tax-free to pay for qualified health expenses. You may even have an employer who makes contributions to your HSA. And in retirement, if you have money left in the account, there are even more qualified expenses, such as Medicare premiums and long-term care expenses.
It’s commonly known that once you enroll in Medicare, you can no longer make pre-tax contributions to a Health Savings Account. What is less widely known is that you can be penalized for making contributions to your HSA in the six months before you enroll in Medicare (which can be age 65 or later if you are still working and have health coverage from your employer). The reason? When you enroll in Medicare, you receive up to six months of retroactive coverage. If you don’t stop HSA contributions at least six months prior to Medicare enrollment, you may get hit with a tax penalty.
Beginning in 1983, the Department of Health and Human Services started retroactively backdating Medicare coverage for six months so people coming off employer health coverage wouldn’t be uninsured while transitioning to Medicare.
The IRS looks at it this way. Because the government gives you six months of Medicare coverage before you actually go on Medicare, and because you can’t make tax-free contributions to a Health Savings Account when you’re on Medicare, then you weren’t eligible to make contributions during that six-month period and you’ve committed an IRS sin—you made excess contributions to your HSA. The IRS then charges you an excise penalty of 6% of the excess contributions. The penalty is charged at the end of the tax year for each year the excess contributions remain in the HSA.
It’s possible to avoid the 6% excise tax if you withdraw the excess contributions and earnings before the tax due date. You have to report the earnings on the excess contributions under the “Other Income” section of your tax return. You do have to pay tax on the earnings but you escape the 6% penalty. If you don’t withdraw the excess contributions before you file your taxes for the year you made those contributions, you will have to file an amended return.
Determining your earnings on excess contributions can be tricky. If you never invested your HSA but left it in cash, the administrator can easily calculate the amount of interest that was earned. But if you invested your account into mutual funds, and especially if you bought and sold shares of those mutual funds during that time, the earnings can be difficult to track.
Another complication is if the employer sends a W-2 showing HSA contributions, whether made by employee or employer. In that case, the HSA owner would have to ask the employer to issue an amended W-2.
But for employer contributions specifically, when contributions have to be reversed, there are two options:
- The employer, technically, can ask for their contributions back, or
- They can recharacterize those amounts and treat them as if they were a post-tax bonus payment to the employee. Many employers choose this option because it would be difficult to recoup their contributions if the employee has already spent the money.
No matter which option a company chooses, they’ll have some record-keeping to adjust.
So, the logical question is, can a person choose to forgo the six months of retroactive Medicare coverage and avoid the issue of HSA excess contributions? Unfortunately, the answer right now is no. But the Centers for Medicare and Medicaid Services (CMS) is considering it.
Disclaimer
This information is presented for informational purposes only and does not constitute an offer to sell, or the solicitation of an offer to buy any investment products. None of the information herein constitutes an investment recommendation, investment advice or an investment outlook. The opinions and conclusions contained in this report are those of the individual expressing those opinions. This information is non-tailored, non-specific information presented without regard for individual investment preferences or risk parameters. Some investments are not suitable for all investors, all investments entail risk and there can be no assurance that any investment strategy will be successful. This information is based on sources believed to be reliable and Alhambra is not responsible for errors, inaccuracies, or omissions of information. For more information contact Alhambra Investment Partners at 1-888-777-0970 or email us at [email protected].
