Participating in an HSA

Just a heads up before we get started, this post assumes you’re a calendar-year taxpayer (you are unless you meet an exception and have elected a non-calendar tax year). I’ll be changing some IRS wording into plain English, which will make this post incorrect for any non-calendar year taxpayers but easier to understand. After all, “December 1st” is a lot easier to read and understand than “first day of the last month of your tax year”.

Health Savings Accounts, or HSAs, are tax-advantaged accounts designed to encourage saving and preparing for future medical expenses. To be eligible for an HSA, you must be covered by a high-deductible health plan (HDHP) on the first day of the month, have no other health coverage (with exceptions), can’t be enrolled in Medicare, and can’t be claimed as a dependent on someone else’s tax return. They encourage people who are paying lower health insurance premiums by being covered by an HDHP to direct some of the money they otherwise would have used on a more expensive plan's premiums to future expenses.

For 2023, the contribution limit is $3,850 for individuals or $7,750 for married couples with family coverage (an increase from $3,650 / $7,300 for 2022).

And one more thing – if you didn’t max out your 2022 HSA contributions and want to, you have until April 18th, 2023 to make 2022 contributions outside of payroll deductions. But if you only contribute through payroll deductions, those will automatically be counted for 2023.

Contribution Limitations and Exceptions

Your annual contribution limit is prorated based on the number of months you’re eligible to participate in an HSA.

For example, if you were an eligible individual with self-only HDHP coverage from January 1 – May 31, 2022, but lost eligibility on June 1, 2022, you’re only allowed to contribute $1,520.83, or $3,650 * 5/12 months, for 2022.

On the other hand, if you became re-eligible to participate in an HSA on October 1 – December 31, 2022, you’d be allowed to contribute $2,433.33, or $3,650 * 8/12 months, instead.

AN EXCEPTION: THE LAST-MONTH RULE

There is an exception to the prorated contribution limit called the “last-month rule”, which states that, “if you are an eligible individual on [December 1st], you are considered an eligible individual for the entire year. You are treated as having the same HDHP coverage for the entire year as you had on [December 1st] if you didn’t otherwise have coverage.” But it’s more complicated than that. To qualify for an HSA for the whole year using the last-month rule, you must remain an eligible individual from December 1st until December 31st the following year (i.e. for this December and all of the following year).

Here are a couple of examples, one where you wouldn’t and one where you would qualify for full-year coverage.

• You became eligible for an HSA on July 1, 2022, and lost eligibility on April 1, 2023. Although you met the initial requirement of the last-month rule (eligible on December 1, 2022), you didn’t maintain eligibility through December 31, 2023. Therefore, your allowed 2022 contribution is $1,825, or $3,650 * 6/12, and your allowed 2023 contribution is $9,62.50, or $3,850 * 3/12.
• You become eligible for an HSA on July 1, 2022, and maintained eligibility through December 31, 2023. Since you met the initial requirement of the last-month rule and remained eligible until December 31, 2023, your allowed 2022 contribution is the full $3,650, and your allowed 2023 contribution is the full $3,850.

Did you notice a problem with this? If you rely on the last-month rule to make a full year’s contribution when you otherwise wouldn’t be able to, you won’t know your actual contribution limit until the end of the following year – long after the April 15th contribution deadline. This can lead to overcontributions, which are included in your income the following year and may be subject to an additional 6% penalty. Make sure to weigh the risks before relying on the last-month rule. Evaluate the probability of losing HDHP coverage, what you’d do if you lost coverage during the testing period, and decide whether it’s worth the risk to make a full-year HSA contribution based on the last-month rule.

If you lose do your job and HDHP coverage while relying on the last-month rule to make full contributions, consider electing COBRA continuation or enrolling in a marketplace HDHP to remain eligible. You'll want to weigh the costs and benefits of these options before making that decision.

COMBINED LIMIT FOR COUPLES: YOU CAN’T GAME THE SYSTEM

I often hear married couples with kids asking, “Can I get the full $7,750 HSA limit for myself plus the kids, while my spouse has self-only coverage for the $3,850 limit?” In short, no. For 2023, $7,750 is your combined HSA contribution limit regardless of how many children you have and who has family vs. individual HDHP coverage.

Now if you’re unmarried with kids, there’s a loophole since each partner is considered a separate tax unit. In this case, you can stack the limits, with one partner getting $7,750 for covering the children and the other getting $3,850 for self-only coverage. But don’t change your marital status just for this.

Tax Benefits

You may have heard HSAs being called “triple-tax-advantaged”. That’s because HSA contributions are made pre-tax (advantage one), taxes on growth are deferred (advantage two), and distributions for qualified medical expenses are tax-free (advantage three). Most tax-advantaged vehicles will have either pre-tax contributions or tax-free withdrawals, but not both, so this makes HSAs unique.

Once you turn 65, you can use HSA funds for non-medical purposes with no penalty, just like your 401k and other retirement accounts. However, those non-medical distributions will be taxable (you lose that third tax advantage).

Another tax benefit of HSAs is if you contribute through payroll deductions, you'll save on both federal income and payroll taxes (Social Security and Medicare). This makes contributing to an HSA through payroll deductions even better than making pre-tax 401k contributions*, which are still subject to payroll taxes. However, if you make an HSA contribution outside of payroll deductions, the contribution will still be excluded from federal income taxes, but won't be excluded from payroll taxes. So, if you have the option to make payroll deductions throughout the year or a one-time contribution outside of payroll, go for the payroll deductions.

*Almost every state conforms to the federal tax treatment of HSAs (the triple-tax advantage), except for California and New Jersey. They don’t view HSAs as tax-advantaged accounts, so you’ll have to pay state income taxes on your HSA contributions, income generated, and capital gains realized. This post discusses the impact of this in more detail.

Using an HSA for Medical Expenses: Now or Wait?

You can either use your HSA for qualified medical expenses right away or invest the money and try to grow it for future expenses. There’s no requirement to have the HSA for a certain amount of time before being able to use it, so whether you decide to use the funds now or invest them for later, you'll get some great tax benefits. If you can afford to pay your medical expenses out-of-pocket and still contribute to your HSA, the compounding effect of tax-free growth and distributions can be very powerful. But if you can't afford to save that money, contributing to your HSA and immediately using it is better than paying with after-tax money.

AN EXAMPLE OF USING AN HSA IMMEDIATELY:

Let's say you have $2,000 in medical expenses this year and your tax rate is 25%. If you pay for all of your medical expenses out-of-pocket (i.e., using regular, after-tax money and not an HSA), you'd need $2,666.67 before taxes. But if you put $2,000 into your HSA and immediately use that money for your medical expenses, you'd be able to avoid $666.67 in taxes, leaving a little more money in your bank account.

Final Thoughts on Using an HSA

If you're covered by a high-deductible health plan, using an HSA is a smart move for its tax benefits. Generally, it's considered better to pay for current expenses out-of-pocket and let your HSA grow, but even using it right away can provide a significant tax advantage.

Most importantly, don’t just select a high-deductible health plan because it has lower premiums or because it gives you access to an HSA. Estimate your “normal” medical costs, imagine your “worst-case” scenario of hitting the out-of-pocket maximums, and evaluate your tolerance for risk (both in terms of risky activities you enjoy and whether hitting a high deductible or out-of-pocket max is an acceptable tradeoff for HSA participation). Also evaluate if being on an HDHP would discourage you from seeking medical care until an issue becomes serious. Paying a $25 copay to see your doctor about a nasty cough is a lot more palatable than having to pay $150 for a visit that's likely to end with, "drink plenty of fluids and lay off the strenuous exercise until it resolves". The risk, of course, is not catching and addressing a more serious issue early on.

Lastly, if your health plan selection is through work and you decide against using a high-deductible plan, explore whether participating in your company’s flexible spending account (FSA) is right for you. They offer similar tax benefits to HSAs, but are "use-it-or-lose-it" – you can't invest and grow your FSA over time.