Understanding the Tax Benefits of Health Savings Accounts

Health savings accounts (HSAs) offer individuals a tax-advantaged way to save for eligible healthcare expenses. As employees review their healthcare coverage during open enrollment, understanding the rules surrounding HSAs can help identify potential tax and financial planning opportunities.

HSAs provide three primary federal tax benefits. Eligible contributions made directly by individuals may be tax-deductible, while qualifying contributions made through an employer may be excluded from taxable wages. Earnings within the account grow tax-free, and withdrawals used for qualified medical expenses are also tax-free. However, contribution limits, eligibility requirements, and distribution rules can affect how these benefits apply.

Understanding HSA Eligibility and Contribution Limits

To contribute to an HSA, an individual generally must be covered by an HSA-eligible high-deductible health plan (HDHP), have no disqualifying additional coverage, not be enrolled in Medicare, and not be claimed as another person’s dependent.

For 2027, the annual HSA contribution limit is $4,500 for self-only coverage and $9,000 for family coverage. Individuals age 55 or older may generally make an additional $1,000 catch-up contribution.

HSA-eligible HDHPs must also satisfy certain deductible and out-of-pocket requirements. For 2027, the minimum annual deductible is $1,750 for self-only coverage and $3,500 for family coverage. Maximum annual out-of-pocket expenses are generally limited to $8,700 and $17,400, respectively.

Employer contributions count toward the annual HSA contribution limit, and the allowable contribution may be reduced when an individual is eligible for only part of the year.

Using HSA Funds for Qualified Medical Expenses

HSA distributions are generally tax-free when used for qualified medical expenses that have not been reimbursed through insurance or another source. Eligible expenses may include deductibles, copayments, prescription medications, dental and vision care, and certain other healthcare costs.

HSA owners may also reimburse themselves for eligible expenses paid out of pocket in an earlier year, provided those expenses were incurred after the HSA was established and were not previously reimbursed or deducted. There is generally no deadline for requesting these reimbursements. However, maintaining receipts and other supporting documentation is important in case the IRS requests substantiation.

Understanding HSA Rules After Age 65

Once an HSA owner reaches age 65, withdrawals used for nonmedical purposes are no longer subject to the additional 20% tax that generally applies to nonqualified distributions before that age. However, nonmedical withdrawals remain subject to ordinary income tax.

HSA funds may also be used tax-free for certain Medicare-related expenses, including Medicare premiums, deductibles, and copayments. Medicare supplemental insurance, commonly known as Medigap, is generally not considered a qualified expense.

Enrollment in Medicare ends an individual’s eligibility to make new HSA contributions, although existing HSA funds remain available for eligible expenses.

Considering HSA Beneficiary Designations

The tax treatment of an HSA after the account owner’s death depends on the designated beneficiary. When a surviving spouse is the beneficiary, the account generally becomes the spouse’s HSA and retains its tax-advantaged status. When a non-spouse individual inherits an HSA, the account generally ceases to be an HSA, and its value becomes taxable income to the beneficiary. If the estate is the beneficiary, the account’s value is generally included on the deceased account owner’s final income tax return. Certain qualified medical expenses of the deceased account owner paid within one year after death may reduce the taxable amount.

Reviewing beneficiary designations can therefore be an important part of broader estate planning.

Planning Considerations

HSAs can provide tax benefits for both current healthcare expenses and future medical costs. Unlike certain other healthcare savings arrangements, unused HSA balances generally carry forward from year to year and may be invested, depending on the account provider.

Individuals should consider their anticipated healthcare expenses, eligibility, contribution limits, and recordkeeping requirements when evaluating how an HSA fits into their broader financial plans.

How LMC Can Help

At LMC, we can help individuals understand HSA contribution and distribution rules, evaluate potential tax implications, and identify planning considerations associated with these accounts. Contact your LMC advisor with any questions about your specific circumstances.