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Clients eager to use the benefits of health savings accounts must steer clear of all-too-common mistakes that could bring large tax payments or big penalties, according to experts.
Financial advisors and tax professionals can help clients avoid pitfalls by reminding them that the HSA advantages of duty-free saving, investment growth and withdrawals come with some strict guidelines, planner Kevin Thompson of Fort Worth, Texas-based 9i Capital Group and Health and Welfare Sales Consultant Cat Torres of Wakefield, Massachusetts-based Sentinel Group told Financial Planning. Potential mishaps include the most typical blunder around HSAs — distributing money toward costs that don't fit the IRS definition of "qualified medical expenses" — and planning for a tax hit if a non-spouse beneficiary inherits an account.
HSA holders who spend money from their account for a nonqualified expense will pay up to 20% of the withdrawal amount as a penalty, Torres noted in an interview. And, if the IRS begins to review the HSA outlays, its auditors are more likely to begin probing other areas of a tax return in a way that "could be very time-consuming and expensive" for the client, she said.
"All of this is going to be included in your tax return. You don't necessarily have to submit receipts or proof of the expense when you file your tax return," she said. "They could go back and say, 'OK, you withdrew $10,000 from your HSA last year. Can you show us the qualified expenses that this was used for?'"
READ MORE: HSAs come with pitfalls — here's how to avoid them
Thompson counts himself "a huge proponent of HSAs," but he counsels clients about the tax impact to any non-spouse heirs who may be in line to receive the assets, he noted. They could avert a potential tax bill to the beneficiaries by draining the accounts of assets to pay medical bills, assigning their HSA to a spouse in their estate plan or considering the use of trusts or charitable gifts, Thompson said.
"It's 100% taxable. It basically becomes an IRA, but it's an IRA that's just immediately distributable to the person who inherits it," he said. "That's one of the few downsides."
Another cautionary area revolves around Medicare, which is an allowable use of the assets for premiums but a potential snag for any clients expecting to work when they're 65 or older. Customers at that age will have to pay taxes on any outlays that aren't for a medical expense, but they aren't subject to the penalties.