Mind the Gap When You Can’t Fund a Health Savings Account

Man in baseball hat jumping from one ledge to another in a canyon

“That’s right – she can use future contributions to reimburse prior eligible expenses that she incurred as far back as when she established her Health Savings Account.”

William G. (Bill) Stuart

Director of Strategy and Compliance

February 4, 2021

Not everyone who opens a Health Savings Account is continuously eligible to fund the account until they enroll in Medicare and is permanently disqualified from additional contributions. It’s important to understand what you need to do to reimburse eligible expenses that you incur during periods when you’re not eligible to fund your account – even using future contributions.

The Problem

American workers are mobile. A federal Bureau of Labor Statistics study published in mid-2020 shows that the average worker will have 12 distinct jobs during their working years. Those changes usually involve moving to a new employer. This movement wouldn’t affect a worker’s eligibility to fund a Health Savings Account if they had portable insurance. But most employees have between one and three employer-sponsored coverage options. And those one to three options vary from employer to employer.

Picture a young worker early in their career. They choose HSA-qualified coverage because they’re generally healthy. Their next employer may offer the same plan, allowing them to continue to fund a Health Savings Account. But the next company doesn’t offer this coverage, or they’re married with a child on the way, and they’re forced to choose another option. They could also opt to enroll in a plan with a lower deductible as the growing size of their family increases their deductible exposure. Perhaps they pick up an HSA-qualified plan two or three jobs later.

It’s a choppy picture. But it’s reality. And workers who understand the rules and act strategically can ensure that they can reimburse tax-free not only eligible expenses that they incur when they’re covered on an HSA-qualified plan, but also eligible services that they receive during periods when they’re not eligible to fund an account – even applying future contributions to reimburse those expenses tax-free.

The Rule

Once you’ve established a Health Savings Account (in most cases, with an initial deposit into the account), you can reimburse all future eligible expenses incurred by eligible family members tax-free for the rest of your life if you maintain a balance. The trick is that requirement to maintain a balance.

Let’s follow the career of Marisa. She’s covered on a parent’s HSA-qualified plan when she starts her nursing career. Someone close to her understands that she’s eligible to open and fund a Health Savings Account. With that person’s help, she establishes an account in her name. She contributes several thousand dollars before she turns age 26 and must enroll on her employer’s plan. But her employer doesn’t offer an HSA-qualified plan. In fact, she goes eight years – to age 34 – and three jobs without enrolling in an HSA-qualified plan. Then, her employer offers an HSA-qualified plan, and she re-enrolls and establishes her eligibility to fund a Health Savings Account.

Can she fund her new account and reimburse eligible expenses that she incurred during that eight-year gap when she wasn’t eligible to contribute?

Maybe. It depends on whether she understands this important concept.

If Marisa had a positive balance in her old Health Savings Account within 18 months of establishing her new account, her establishment date on the new account reverts to the establishment date of her original account.

Example: Marisa opened her original Health Savings Account in 2010 and contributed through 2013. She then became HSA-eligible again January 1, 2021. If she had a positive balance in her account on July 1, 2019 (18 months prior to January 1, 2021) or later, her new account is established as of the 2010 establishment date. She can reimburse tax-free all eligible expenses that she’s incurred since 2010.

The financial benefit to Marisa is enormous. She probably didn’t fund her account to the maximum allowed by law between 2010 and 2013. Few young people do. She may have had a $1,000 balance when she lost her eligibility to continue to fund her Health Savings Account. She may have forgotten about the account as she incurred $9,500 of eligible expenses – perhaps a root canal, her contact lenses, an MRI and some physical therapy for an ankle injury, and a prescription. She paid those expenses with personal funds.

Marisa can fund her new Health Savings Account and then withdraw funds to reimburse tax-free any of those $9,500 of expenses that weren’t reimbursed by another tax-advantaged program, such as a Health FSA. That’s right – she can use future contributions to reimburse prior eligible expenses that she incurred as far back as when she established her Health Savings Account.

The Mechanics of Reimbursement

Here’s how Marisa can enjoy the tax benefits of her new Health Savings Account. She has family coverage, so she can contribute up to $7,200 in 2021, less the $2,000 lump-sum that her employer contributes at the beginning of the year. That leaves her with a $200 payroll deduction for each of her 26 pay periods.

Marisa keeps a $2,000 balance in the account to cover current expenses. Every month, she withdraws $400 and places that money in her personal checking account, or – even better – in a Roth Individual Retirement Arrangement or a Roth 401(k) if she’s eligible to fund one of these accounts. At the end of the year, she’s withdrawn $4,800 from the account. She pairs those distributions with $4,800 of the $9,500 of eligible expenses that she incurred between 2010 and 2014. She repeats the process the following year as well.

By the end of Year 2 (she can stretch it out longer if she wishes), she’s reimbursed herself for the $9,500 of eligible expenses. She’s reduced her taxable income by $9,500, saving herself almost $3,600 in taxes (at a 24% federal marginal income tax rate, 7.65% in FICA taxes, and a 6% state marginal income tax rate).

Proper Planning

Sadly, most people aren’t as enlightened as Marisa in our example. At least until now. Here’s what you need to do to make sure you preserve your opportunity to reimburse tax-free eligible expenses that you incur between periods of eligibility to fund a Health Savings Account:

  1. Open and fund your account promptly. You want to establish your account as soon as you can. Under the laws of most states, you establish your Health Savings Account when your first deposit is recorded. (Health Savings Accounts governed by Utah state trust law have a more liberal standard.)
  2. If you lose your eligibility to fund an account, be sure you have a positive balance. Remember, you can fund your account up to the time that you file your personal income tax return for that tax year. In our example above, Marisa lost her eligibility at the end of 2013. She could continue to fund her Health Savings Account through April 15, 2014, for the 2013 tax year.
  3. Make sure fees don’t eat up your balance. Employers often pay monthly account fees for employees who are actively funding their accounts. But that support often stops when the worker switches coverage (and definitely when she changes jobs). Most account administrators deduct fees directly from your account, thereby draining your balance. You need to protect yourself by rolling your balance into a new Health Savings Account with no fees.
  4. Keep receipts. You benefit from the strategy of reimbursing eligible expenses incurred between periods of eligibility with future contributions only if you can match those future contributions with eligible expenses incurred since you established your old Health Savings Account. If you didn’t save or can’t retrieve receipts, reimbursing those expenses tax-free will backfire if your income tax return is audited. You’ll have to pay taxes and penalties – even if the expenses were eligible – if you don’t have the back-up paperwork to substantiate that the expenses qualify for tax-free distributions from a Health Savings Account.
  5. Understand how to make withdrawals from your new account. Your Health Savings Account debit card won’t help you distribute funds to reimburse yourself for old expenses. Your account provider must offer at least one other method of withdrawing funds. The most common method is your requesting a reimbursement, which the provider sends electronically to your personal account. Your Health Savings Account provider can’t ask for documentation to substantiate any request for reimbursement.

Real Life

My 24-year-old daughter and 23-year-old son both have established Health Savings Accounts. They didn’t understand what they were signing – I just told them to sign. I made initial deposits into their fee-free accounts. There’s no risk that they’ll spend the money, since they don’t know that they own these accounts (and they don’t read my articles). The account paperwork comes to me.

Imagine the value of this gift. They need to maintain some paperwork (which I’m happy to keep if they give it to me). They don’t need to document every eligible expense. But copies of Explanations of Benefits from their medical insurer, receipts for contact-lens purchases and major dental work, and an annual print-out from the pharmacy may yield thousands of dollars of tax savings for them years from now. That seem like a good deal for them.

What We’re Reading

What percentage of average household savings are Health Savings Account balances? Learn more here about this untapped opportunity in the savings hierarchy.

You can’t use Health Savings Account funds to purchase face masks or hand sanitizer. A bipartisan bill introduced in the House of Representatives aims to change that. But you can use balances to purchase eye protection.

Did you know that you can execute a once-per-lifetime rollover of funds from an Individual Retirement Arrangement to a Health Savings Account? Learn about the rules here.

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