By William G. (Bill) Stuart
Director of Strategy and Compliance
Benefit Strategies LLC
July is a popular month to begin a new medical benefit year. A growing number of employers are offering HSA-qualified medical plans, and often their benefit years start on a date other than January 1. In this paper, we focus on how much individuals can contribute to their HSAs when their eligibility to contribute begins or ends mid-year. This can occur due to:
- Their new plan starts mid-year
- They become HSA-eligible mid-year under other circumstances (such as new hires or individuals ending coverage under a traditional Health FSA)
- They lose HSA eligibility during the year (such as no longer being enrolled in a HSA-qualified medical plan or enrolling in Medicare)
The general rules
The Internal Revenue Service (IRS) sets annual contribution limits, with separate limits for Self-only and Family coverage. (Note: Family coverage includes any policy that covers more than one individual, even if the employer has established additional rating tiers such as Employee+1, Employee+Spouse or Employee+Child.) The maximum calendar-year contribution limits from all sources, including employer, are:
Self-only: $3,350 in 2016 and $3,400 in 2017
Family: $6,750 in both 2016 and 2017
In addition, individuals who are age 55 or older at any point during the year can contribute an extra $1,000 catch-up contribution. Spouses who are age 55 or older and HSA-eligible can make a catch-up contribution into their own HSA, even though they’re not the medical plan subscriber.
The annual contribution limit is tracked on the calendar year, regardless of when coverage begins. Individuals must be HSA-eligible on the first day of all 12 months of a calendar year to make the maximum contribution with no follow-up compliance (a concept that will become clearer in a moment).
HSA eligibility and contribution limits
Individuals are HSA-eligible for any month during which they meet all eligibility criteria as of the first day of that month. Briefly, eligibility criteria include being enrolled in an HSA-qualified medical plan, not being someone else’s tax dependent and not being enrolled in disqualifying coverage, including Medicare, Medicaid and a traditional Health FSA through their own or a spouse’s employer. For more information on HSA eligibility, please see our booklet Health Savings Account GPS: The authoritative guide to HSAs, which you can find here.
Individuals who gain eligibility between January 2 and December 1 of a given year can either pro-rate their contributions or make a full contribution to their HSAs. Here are the two approaches:
Pro-rate: Reduce total contributions to reflect the number of months of HSA eligibility. This method is mandatory for accountholders who lose HSA eligibility before the end of the year. It’s one of two options for individuals who become HSA-eligible between January 2 and December 1.
In this approach, simply divide the maximum contribution permitted for the HSA coverage tier (Self-only or Family) by 12 to calculate the monthly maximum contribution, then multiply that figure by the number of months eligible. For example an individual under age 55 with Self-only coverage who becomes HSA-eligible on August 1, 2016 would follow this calculation:
- Maximum Self-only contribution permitted in 2016: $3,350
- $3,350 ÷ 12 months: $279.17
- Number of months eligible in 2016 (August – December): 5
- $279.16 X 5 months: $1,395.85
This individual can contribute up to $1,395.85. If the individual was age 55 or older, they would follow the same calculation to determine the additional pro-rated catch-up contribution they are eligible to make ($1,000 ÷ 12) X 5, or $416.67.
Similarly, an individual under age 55 with Family coverage who loses HSA eligibility on May 6, 2017 would follow this calculation:
- Maximum Family contribution permitted in 2017: $6,750
- $6,750 ÷ 12 months: $562.50
- Number of months eligible in 2017 (January – May): 5
- $562.50 X 5 months: $2,812.50
This individual can contribute up to $2,812.50.
Refer to the chart below to find the maximum contribution for the number of months that an individual is HSA-eligible in 2016.
|12||$ 3,350.00||$ 6,750.00||$ 1,000.00|
|11||$ 3,070.83||$ 6,187.50||$ 916.67|
|10||$ 2,791.67||$ 5,625.00||$ 833.33|
|9||$ 2,512.50||$ 5,062.50||$ 750.00|
|8||$ 2,233.33||$ 4,500.00||$ 666.67|
|7||$ 1,954.17||$ 3,937.50||$ 583.33|
|6||$ 1,675.00||$ 3,375.00||$ 500.00|
|5||$ 1,395.83||$ 2,812.50||$ 416.67|
|4||$ 1,116.67||$ 2,250.00||$ 333.33|
|3||$ 837.50||$ 1,687.50||$ 250.00|
|2||$ 558.33||$ 1,125.00||$ 166.67|
|1||$ 279.17||$ 562.50||$ 83.33|
The advantage of the pro-rating rule is that accountholders have no compliance requirements in the future (more in a moment). The disadvantage is that pro-rating might not allow them to make a contribution sufficient to cover eligible expenses, and it certainly doesn’t minimize their tax bills. The alternative, available to those who become HSA-eligible by Dec. 1, is the last-month rule.
Last-Month Rule: In late 2006, Congress approved a second option. Under this provision, individuals can contribute up to the maximum annual contribution for a year as long as they were HSA-eligible as of December. 1. They must, however, remain HSA-eligible through the end of the following calendar year (a span of time known as the testing period). If they lose HSA eligibility during that time, any contributions in excess of the pro-rated amount are included in their taxable income and subject to a penalty equal to an additional 10% tax on the excess contribution.
The last-month rule allows individuals to minimize their tax burden and maximize HSA balances to reimburse current expenses or save for future expenses. The cost is the potential penalties for failure to remain HSA-eligible.
Individuals who fail to remain HSA-eligible through the testing period must, as noted earlier, withdraw all contributions in excess of the pro-rated maximum (and earnings on that excess contribution, which in today’s interest-rate environment is minimal) and pay an additional 10% tax as a penalty. Here are a couple of tips to minimize the impact of losing eligibility during the testing period.
Correct the error: Accountholders who lose HSA eligibility during the testing period and before they file their personal income tax return for that tax year can withdraw the excess contribution (and earnings on it) from their HSAs and include it in their taxable income without incurring a penalty. For example, an individual who was married Feb. 19, 2016, and switched coverage to her spouse’s non-HSA-qualified plan could have included any excess contribution from 2015 in her taxable income on her 2015 personal income tax return. She would face no 10% penalty.
Recontribute the funds in the current year: Individuals may be able to redeposit the money into their HSA as a contribution for the following year to minimize the income tax liability. In the example above, the newlywed could work with her employer (if she made the contributions through pre-tax payroll) and Benefit Strategies or just Benefit Strategies (if she contributed personal funds) to classify up to $558.33 of her $1,000 excess 2015 contribution as a 2016 contribution. Because she’ HSA-eligible in January and February, she can contribute up to that amount in 2016.
Evaluating the approaches
Should an individual who becomes HSA-eligible, say, July 1, adopt the pro-rated or last-month rule approach to HSA contributions? The answer depends on several factors:
Expenses: An individual enrolled in Self-only coverage with a $2,500 deductible can contribute no more than $1,675 in 2016 using the pro-rated method. If the individual has, say, $3,000 worth of deductible, dental and vision expenses, it probably makes sense to use the last-month rule and contribute $3,000 maximum, unless the individual believes that she won’t remain HSA-eligible through the end of the following year. Here’s why: By contributing the extra $1,325, she saves about $375 in taxes. If she subsequently loses HSA eligibility before the end of the testing period, she’ll have to pay that $375 in taxes and an additional $132.50 (10% of $1,325 excess contribution) as a penalty. The reward ($375 in tax savings) is worth almost triple the risk ($132.50). If the probability of risk is small (less than one-third), this individual would be better off using the last-month rule.
Federal marginal income tax rate: The higher the rate that an individual pays on the last dollar of income earned, the more attractive the last-month rule becomes. A husband and wife who file jointly with a taxable income of $74,900 pay a marginal tax rate of 15%. If they increase their taxable income the following year by $6,000, they pay 25% of that additional $6,000 in taxes – an increase from $900 (at 15%) to $1,500 (25%). For them, the $600 difference in potential tax liability is less than the 10% additional tax penalty as long as their excess contribution doesn’t exceed $6,000. These individuals – indeed, any taxpayers subject to 25%, 28%, 33%, 35% and 39.6% marginal federal income tax rates should seriously consider using the last-month rule.
Probability of losing eligibility: Some individuals know that they’ll lose HSA-eligibility before the end of the following calendar year, especially when the clock starts ticking early like an April 1 eligibility date, which requires remaining HSA-eligible for an additional 21 months, versus a Nov. 1 eligibility date that creates a 14-month period of additional eligibility. Individuals who are planning major life events (retirement, relocation, marriage and coverage under a spouse’s plan) or work for a company or in an industry in which continued employment is risky, should weigh the risks vs. rewards carefully before adopting a contribution approach.
Risk-tolerance: Some individuals seek to minimize risk whenever possible, even at the expense of foregoing potential rewards. Such an individual probably sleeps better at night contributing no more than the pro-rated maximum, knowing that he won’t be subject to penalties if he doesn’t remain HSA-eligible through the testing period. Pro-rating may not make total sense from an objective, dispassionate financial perspective, but it offers non-financial benefits to this accountholder.
The good news is that accountholders don’t have to make a binding decision at any point. Individuals who planned to adopt the pro-rating approach and then find that they have additional expenses can increase their HSA contributions above the pro-rated maximum. Similarly, those who followed the last-month rule, then lost their HSA eligibility in March, can withdraw the excess contributions (plus any earnings on those funds), include that amount in their taxable income and avoid penalties. They must complete the withdrawal before they file their personal income tax return for the year that the overfunding occurred.
- Individuals who aren’t HSA-eligible all 12 months of a calendar year must understand that they potentially face lower contribution limits than the maximum annual contribution for their contract type, regardless of when their HSA-qualified plan is introduced or renews.
- Accountholders who lose HSA eligibility before Dec. 1 must pro-rate their contributions.
- Individuals who meet all HSA eligibility criteria as early as Jan. 2, but no later than Dec. 1, have a choice of (a) pro-rating their contributions or (b) depositing up to the maximum contribution and remaining HSA-eligible through the end of a testing period to avoid taxes and penalties.
4. Individuals who become HSA-eligible after Dec. 1 can’t make a contribution for that year, since HSA eligibility is based on status as of the first day of the month.
A great resource on HSAs is IRS Publication 969, published annually. See pages 4 through 8 for more information on HSA contributions.
What we’re reading this week
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