Updated on January 4, 2008.>
IF YOU'VE BEEN hoping to start up a health savings account (HSA) or make bigger contributions to your existing HSA, you're in luck. A largely unpublicized piece of legislation passed in 2006 created expanded contribution opportunities. But before you start pouring in money, you should know that some of the new rules aren't as tax-friendly as advertised. Here's a look at HSAs and the latest rules that govern them:
People like HSAs because you can make annual deductible contributions, which lower your income tax bills, and then take tax-free withdrawals to pay for uninsured medical costs. If you have minimal medical expenses, your HSA balance can build up to a substantial figure over the years. However, you're only allowed to put money in an HSA if you're covered by a high-deductible health plan, or HDHP. To qualify as an HDHP in 2008, a plan must charge an annual deductible of at least $1,100 for self-only coverage or at least $2,200 for family coverage.
HSA Contributions No Longer Limited to HDHP Deductible
One of the biggest bonuses of the new rules is that almost everyone can contribute more money to their HSAs. The maximum amount you can put toward your account no longer depends on the size of your HDHP deductible. That's great news. Previously, your annual HSA contribution could not exceed the deductible amount.
To help you determine whether you should sign up for an HSA, click here
Eligible in December Now Means Eligible All Year
Previously, your HSA contribution eligibility was determined on a month-by-month basis. So if you started being covered by an HDHP part way through the year, you could only contribute a pro-rated amount for that year.
Now, if you're eligible to make HSA contributions in December, you're considered eligible for the entire year. So if you're covered by an HDHP this coming December, you can generally contribute the maximum amounts: up to $2,900 for the 2008 tax year if you have self-only coverage or up to $5,800 if you have family coverage (plus the extra $900 if you're 55 or older). All of this sounds great, but there are a few things you should consider before signing on.
While the ability to make a larger contribution based on end-of-year eligibility status is helpful, a harsh recapture rule will apply if you become ineligible for contributions during the "testing period." The testing period begins with the last month of the year that you take advantage of the new rule to make a larger contribution. The period ends on the last day of the 12th month following that month.
If you're affected by the recapture rule, you must include the recapture amount in your taxable income. Then get ready to be hit with a 10% penalty tax too. To figure out the recapture amount, figure out the difference between the larger contribution that you make under the new end-of-year eligibility rule and the smaller pro-rated contribution you would have been allowed under the old month-by-month eligibility rule.
It's a bit confusing, so here's an example:
Say that on Dec. 1, 2008, you become covered by an HDHP that provides self-only coverage. Under the new end-of-year eligibility rule, you can make a deductible HSA contribution for 2008 of up to $2,900. If you do so and then become ineligible for HSA contributions anytime in 2009 say, because you obtain coverage under a more generous health plan then you'll get hit with the recapture rule.
On your 2009 Form 1040, you must report recapture income of $2,658. Plus, you'll get socked with a 10% penalty tax of $266. To clarify, the recapture amount is the difference between the $2,900 you contributed under the new end-of-year eligibility rule and the $242 you could have contributed under the old month-by-month eligibility rule. Here's the math: $2,900 - (1/12 x $2,900) = $2,658.
Bottom line: With this nasty recapture rule hanging over your head, you may be unenthusiastic about making a full HSA contribution for 2008. Who can blame you?
New Health-Account-to-HSA Rollover Privilege
The new rules also allow you to roll over a distribution from a health care flexible spending account (health FSA) or health reimbursement arrangement (HRA) into your HSA. This is a tax-free maneuver. However, the rollover contribution cannot exceed the smaller of:
The balance in your health FSA or HRA as of Sept. 21, 2006, or
The balance in your health FSA or HRA as of the distribution date.
To qualify, you must completely drain the health FSA or HRA and cease participating in it after the rollover. Only one account-draining rollover is allowed for each health FSA or HRA that you own. So this is not something you can do repeatedly.
Unfortunately, a punitive recapture rule will apply if you make a rollover and then become ineligible to make HSA contributions during the subsequent "testing period." This testing period begins with the month of the rollover, and it ends on the last day of the 12th month following that month. If the recapture rule applies, your entire rollover contribution amount must be included in your taxable income, and you'll get hit with a 10% penalty tax.
Here's an example:
Say that on Sept. 21, 2006, you had a $2,500 balance in your health FSA. At the end of 2007, your FSA balance is $2,000. You tell your employer you won't participate in the FSA for 2008, then you sign up for HDHP coverage for 2008. In January of 2008, you take advantage of the new FSA-to-HSA rollover privilege by rolling over $2,000. The rollover drains your FSA and jump-starts your HSA. So far, so good.
But what if you become ineligible for HSA contributions on July 1, 2008, because you obtain coverage under a more generous health plan? It's not pretty. Since ineligibility occurs during the testing period, you must recapture the entire $2,000 rollover amount by reporting it as income on your 2008 Form 1040. Plus, you'll have to pay a 10% penalty tax of $200.
Bottom line: Once again, we wouldn't blame anyone who thinks this nasty recapture rule makes the health-account-to-HSA rollover idea look too dicey.
New IRA-to-HSA Rollover Privilege
You can also make a tax-free rollover from your IRA into your HSA. This is yet another way to jump-start your HSA.
However, the rollover amount cannot exceed your "regular" HSA contribution limit for the year, based on whether you have self-only or family HDHP coverage. So the maximum you can roll over in 2008 is $2,900 if you have self-only coverage or $5,800 if you have family coverage. Afterward, your "regular" deductible HSA contribution limit for the year is reduced by the amount of any IRA-to-HSA rollover. You can generally make only one such rollover during your life.
As you might expect, a devilish recapture rule can bite you in the wallet if you do a rollover and then become ineligible for HSA contributions during the subsequent "testing period." The testing period in this instance begins with the month of the rollover contribution and ends on the last day of the 12th month following that month. If you fall victim to the recapture rule, you must include the entire amount of the rollover contribution in your taxable income and pay a 10% penalty tax.
Here's an example:
Say you have family HDHP coverage for this year. On Oct. 1, 2008, you decide to roll over $5,800 from your IRA into your HSA. This puts a substantial amount of money into your HSA without any cash-flow problems.
But what if you become ineligible for HSA contributions in September of 2009? Since ineligibility occurs during the testing period, you must recapture the entire $5,800 by reporting it as income on your 2009 Form 1040. To add insult to injury, you must also pay a 10% penalty tax of $580. Assuming you have enough cash to make a "regular" deductible HSA contribution for this year, you would be better off taking that course because it avoids any chance of the nasty recapture rule coming into play later on.
The new HSA rules can prove helpful by allowing for larger annual contributions and tax-free rollovers from health care accounts and IRAs. However, don't take advantage of these new rules unless you're confident that the dreaded recapture provisions won't hurt you later on. So get out your crystal ball, and good luck with your predictions.