Health Savings Accounts: Benefits and Potential IRS Pitfalls

Health Savings Accounts (HSA) have become increasingly more popular choices for both employers and individuals as they look to offset the rising costs of healthcare and insurance premiums. In fact, according to the 2020 Midyear Devenir HSA Research Report, the HSA market will approach 35 million accounts by the end of 2022, holding over $100 billion in assets.

What are the Benefits of an HSA?

HSAs, which are tax-exempt trusts or custodial accounts that can be set up with a qualified HSA trustee to pay or reimburse certain medical expenses, offer many benefits, including the ability for individuals to:

  • Claim tax deductions for contributions made even if deductions aren’t itemized on their tax return;
  • Exclude contributions made by their employer from their gross income;
  • Keep contributions in their account until they are used;
  • Maintain the account balance even if they change employers or leave the workforce; and
  • Report earnings and allow distributions to remain tax-free if used for qualified medical expenses.

Tax-free distributions from an HSA can be made to pay or be reimbursed for qualified medical expenses, which include expenses that would generally qualify for the medical and dental expense itemized deduction on Schedule A. If individuals use their HSA for a non-qualified expense, they will owe income tax on that amount and pay an additional 20 percent penalty fee.

For example, a taxpayer in the highest tax bracket who used a $5,000 HSA distribution for non-qualified expenses would be subject to $2,850 in additional income taxes. Because of this, the IRS has actively enforced compliance with these plans. In addition, distributions must also be properly accounted for on the annual income tax return or the IRS will send a Notice CP2000 proposing the assessment of the income tax plus the 20 percent penalty on the HSA distribution.

How to Stay Compliant

Recordkeeping for IRS purposes doesn’t have to be burdensome. Individuals who have an HSA account should:

  • Keep all receipts and documentation to prove the HSA was used for eligible medical expenses, including for vision or dental services;
  • Maintain a spreadsheet that summarizes each medical service, including the date of the service, the service provider’s name, the payment amount and details for any supporting bills or receipts;
  • Save monthly statements that are provided by their HSA administrators that detail withdrawals and expenses; and
  • Keep the insurer’s explanation of benefits statement that documents the expenses for services covered under the plan, especially if it is for a high deductible health plan (HDHP).

We’re Here to Help

Bennett Thrasher’s Tax Controversy practice helps clients resolve IRS matters, including how to navigate complexities related to their Health Savings Accounts. To learn more about these services, please contact James Pickett by calling 770.396.2200.