HSA Shoebox Rule: The Smart Tax Strategy to Save Money

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Health Savings Accounts (HSAs) are popular but often underutilized. HSAs offer unmatched tax benefits, better than IRA accounts, and with the Shoebox Strategy, the additional tax benefits can become very significant over time if the strategy is implemented correctly.

If you qualify for a Health Savings Account, then knowing how to maximize your tax benefits through the Shoebox Strategy will allow you to earn and spend a substantial amount of permanently tax-free income. In this article, we will discuss the basic rules of an HSA account and give you step-by-step instructions on how to implement the tax-advantaged method.

WHAT IS AN HSA ACCOUNT AND HOW DOES IT WORK?

An HSA is a tax-advantaged account to pay for health care costs. Contributions to the account are tax-free and distributions from the account are tax-free as long as they are spent on qualified medical expenses.

If an employee is included under an employer-sponsored plan, and their employer contributes to that employee’s HSA account, then the amount is excluded from income, and if an employee contributes to their own HSA, then it is a tax deduction that reduces income.

HOW DO YOU QUALIFY FOR AN HSA ACCOUNT?

You must be considered an “eligible individual” to contribute to an HSA. This means that you must meet the following requirements:

  • Have coverage under a High-Deductible Health Plan (HDHP) on the first day of the month.
  • Not have certain other health care coverage, such as a non-high deductible medical plan. You may have a dental, vision, or long-term care and still be eligible.
  • Not be enrolled in Medicare
  • Not be a dependent on someone else’s tax return

A High-Deductible Health Plan is defined as a plan with a higher annual deductible than typical health plans and a maximum limit on annual deductible and out-of-pocket medical. (For current limits and information on out-of-pocket costs, see the IRS website)

Luckily, insurance coverage providers will usually label plans as HSA eligible, high deductible health plans. So, as long as you meet the other requirements outlined, you shouldn’t have to double-check the medical plan requirements to make sure it is HSA eligible.

HOW MUCH CAN YOU CONTRIBUTE TO AN HSA IN 2021?

For 2021, If you have self-only HDP coverage, then the contribution limit is $3,600; if you have family HDHP health coverage, then the contribution limit is $7,200. The contribution limits adjust annually for inflation.

If you are 55 years or older, then the IRS allows an HSA catch-up contribution of an additional $1,000 for self and family coverage (resulting in $4,600 and $8,200 for the 2021 limits).

If you accidentally overcontribute, you can correct the mistake by withdrawing the excess contribution before filing your income tax return by the deadline (4/15 without an extension or 10/15 with an extension). If you do not remove the excess, then there is an annual 6% excise tax until you correct the mistake.

WHAT ARE QUALIFYING MEDICAL EXPENSES?

Qualifying health expenses that result in tax-free distributions from your HSA are eligible expenses that:

  • Are incurred after the HSA is established; and
  • Are incurred by you, your spouse, and your dependents; and
  • Are spent on certain types of medical costs:
    • General Rule: Expenses intended to primarily alleviate or prevent a physical or mental disability or illness (excludes items merely beneficial, like vitamins or a vacation)
      • Costs for medical services of medical practitioners
      • Costs of equipment, supplies, and diagnostic devices
    • Examples:
      • Doctor visits
      • Prescription and over-the-counter medicine
      • Dental expenses such as teeth cleanings, sealant application, or treatments to alleviate dental disease
      • Eye examinations
      • Long-term care insurance (with some limits)

If you are interested in a full sortable list of qualifying and non-qualifying expenses, Optum Bank has provided a great tool here.

WHAT IS NOT A QUALIFIED MEDICAL EXPENSE?

Generally, expenses that are considered non-medical expenses are payments for items that are elective or expenses that, while beneficial to general health, are not primarily intended to alleviate or prevent a medical condition. For example, gym memberships or any cosmetic expense such as plastic surgery or dental veneers are not covered unless deemed medically necessary.

If you’re planning to use HSA funds for an expense that is typically elective or for general health, even if it is medically necessary for you, you should be keeping the necessary support. The support will usually include a doctor’s note and can also include additional records showing your circumstance.

Other non-medical expenses that are not covered include funeral services, childcare, maternity clothes, and missed appointment fees. While this is not an all-inclusive list, it provides an idea of the types of expenses that are usually not covered by HSAs. Since the majority of medical expenses are covered by HSAs, especially the types of expenses that are usually highest cost, it is usually not difficult for you to ensure you have enough qualifying medical expenses to cover the distributions from your HSA in a given year.

WHAT IS THE TAX BENEFIT OF AN HSA?

The most immediate tax benefit, even if you contribute and spend the HSA funds without implementing the Shoebox Strategy, is that employee or employer contributions directly through payroll are not subject to income or payroll tax by offering it through a Section 125 plan.

Example:

A $7,200 contribution for family coverage will save you $550.80 in payroll taxes as an employee and will save your employer $550.80. If you are self-employed, then you will save a total of $1,101.60 in payroll taxes. In addition, you will save taxes based on your income tax rate. So if you are in the 24% tax bracket, then you will save $1,728 in income taxes. In total, as a self-employed individual, you will have saved a total of $2,829, or as an employee, you will have saved $1,278.80 by contributing $7,200 to your family’s HSA.

What is superior about these tax savings compared to a pretax IRA or 401k is

1) an HSA saves on payroll tax and a pretax IRA does not, and

2) it is a permanent tax reduction, rather than a temporary tax deferral.

While the tax savings in this example are significant, HSAs allow even more opportunity to minimize tax through the Shoebox Strategy.

THE HSA SHOEBOX STRATEGY: STEP BY STEP

The HSA Shoebox Strategy is the way to maximize your tax benefit from your HSA account, and we see very few taxpayers doing it. It’s a way to take the most advantage of what’s considered the triple-tax advantage (pre-tax contributions, earnings are tax-free, and withdrawals for qualified medical are tax-free).

The basic premise behind this strategy is to contribute to an HSA each year, “shoebox” your receipts, invest the funds in securities, and withdraw in retirement tax-free. The steps below outline the opportunity afforded by this shoeboxing strategy.

1. Pay medical expenses out-of-pocket rather than from your HSA.

If you pay for medical expenses out-of-pocket, you can continue to build and earn interest on the money in your HSA.

2. File and store your medical receipts for qualifying medical expenses over the years.

Keep track of your reimbursements, explanations of benefits, and invoices by saving them online or in a “shoe box” for later reference.

3. Invest the HSA funds.

By investing your HSA funds with a smart strategy, you can grow your investments tax-free.

4. Once you are ready for retirement, reimburse yourself for prior years of qualifying medical expenses from HSA funds.

Withdrawals made at any age are tax-free and penalty-free when reimbursing for qualified medical expenses incurred since the time you qualified to contribute to an HSA.

5. Enjoy retirement from funds that were tax-free contributions and tax-free earnings!

By using this strategy, you enjoy all three advantages of the HSA – pre-tax contributions, no taxation on earnings, and withdrawal tax-free. Once you reach age 65, even if you withdraw funds for reasons other qualifying medical expenses, the distributions are penalty-free and only subject to ordinary income taxes.

6. Since there are no required minimum tax-free distributions for HSAs, keep the funds invested as long as you want.

You don’t need to make annual withdrawals until you’re ready to retire. You may choose to leave some or all of the investment gains untouched while you work longer.

Based on IRS guidance, there is no time limit for reimbursing yourself for qualifying medical expenses from your HSA. This is the significant rule that makes it easy to use an HSA as a superior retirement account to other more traditional options. With no time limit, you can save up all qualifying medical expenses over the years, and then reimburse yourself 20 years later when you need the funds for other reasons. Just make sure to keep the records to support the medical reimbursement!

HSA MISTAKES TO AVOID ON TAX REPORTING FOR YOUR HSA

HSA contributions and distributions are reported on Form 8889. The top two common mistakes we see on income tax returns are:

1. Forgetting to report contributions you make to your HSA that are not automatically withheld from your paycheck.

Often, HSA contributions are disclosed on your annual Form W-2 under Box 12, Code W, when contributed by you or your employer and automatically deducted from your income. If this is the case, as long as your reporter has provided you with an accurate Form W-2, you shouldn’t have any issues reporting your HSA contributions.

However, it is also very common for employees or self-employed individuals to contribute directly to their HSA without an automatic deduction run through payroll. When this happens, your tax preparer does not know about the contribution unless you provide the information. Very often we see taxpayers provide us prior-year tax returns where they had assumed their HSA contributions were getting deducted on the tax return, but the itemized deduction was not reported. This is most likely because the tax preparer did not specifically ask about it, and the taxpayer thought one of their tax forms provided would have communicated this information when that is usually not the case.

This error results in losing a primary tax benefit of an HSA. Therefore, we always recommend double-checking your income tax return once it’s prepared and looking out for the deduction reported on Form 8889, which will show the contributions. Then, you can also look out for the deduction on Schedule 1, Part II, Line 12 of your tax return if the contribution was not reported through payroll on your W-2.

2. Omitting HSA distributions spent on qualifying health care expenses reported to you on Form 1099-SA

This mistake is by far the most common HSA tax reporting error we see on tax returns. If you take any type of distribution from your HSA during the tax year, which is most commonly done by using your HSA card directly on qualifying health expenses, such as at your doctor’s office, then you will receive a Form 1099-SA. This form is often received electronically through your HSA trustee’s online portal. Since HSAs often have fewer regular contributions and activities than IRAs and are held at institutions that are lesser-known, we find that taxpayers are less familiar with logging into their accounts and do not download their annual Form 1099-SA to provide to their tax return preparer.

When you do not report your HSA on Form 8889, the IRS reports them for you and assumes all distributions. The IRS system contains the tax documents that were reported under your name and social, such as Form 1099-SA, and it matches them to the income tax return you file. This means that you do not have to get audited for the IRS to catch a mistake in omitting the HSA distributions from your return. Instead, the mistake is caught automatically by the IRS computer software, which then generates a notice adding the taxable income to your return. The burden is then placed on you to show the proposed additional tax is incorrect. You’re then in a position where you not only have to pull all the support to submit, but you have to make sure you timely respond to the IRS notice and follow the required procedure to disagree with the notice. If you do not respond timely, for example, because you moved addresses and never receive the notice, then the IRS will issue a notice of deficiency and add the tax to your return, in addition to assessing penalties and interest.

To avoid this mistake, always log in to your HSA trustee’s online account and make sure you download all available tax documents. If you know that you spent HSA funds during the tax year, then you will have a tax document to report, so make sure to provide it to your tax preparer.

CONSULT WITH AN EXPERIENCED TAX PROFESSIONAL

At DiLucci, our experienced team of tax professionals is here to help you with your individual or business tax needs, including assistance with health care spending and HSA accounts.

Our services include:

As always, we’re here to help. Click here to schedule a consultation with our office and we’ll follow up with you promptly.