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October 5 , 2008 - I'm looking for a way to cover my family's medical expenses and save taxes at the same time. Can a health savings account accomplish this?

Given the ever-escalating cost of providing employee health care benefits, a health savings account (HSA) can be a more cost-effective method of providing these benefits. For eligible individuals, HSAs offer a tax-favorable way to set aside funds to meet future medical needs. Here are the key tax-related elements:

  • contributions you make to an HSA are deductible, with limits,
  • contributions your employer makes aren't taxed to you,
  • earnings on the funds within the HSA are not taxed, and
  • distributions from the HSA to cover qualified medical expenses are not taxed.

To be eligible for an HSA, you must be covered by a “high deductible health plan”. You must also not be covered by a plan which (1) is not a high deductible health plan, and (2) provides coverage for any benefit covered by your high deductible plan.

For 2008, a “high deductible health plan” is a plan with an annual deductible of at least $1,100 for self-only coverage, or at least $2,200 for family coverage. For self-only coverage, the 2008 limit on deductible contributions is $2,900. For family coverage, the 2008 limit on deductible contributions is $5,800. Additionally, annual out-of-pocket expenses required to be paid (other than for premiums) for covered benefits cannot exceed $5,600 for self-only coverage or $11,200 for family coverage.

An individual (and the individual's covered spouse as well) who has reached age 55 before the close of the tax year may make additional “catch-up” contributions for 2008 of up to $900.

If you are an eligible individual on the first day of the last month of your tax year, you are considered to be an eligible individual for the entire year. However, you must remain an eligible individual during the testing period, which begins with the last month of your tax year and ends on the last day of the 12 th month following that month (for example, December 1, 2008 - December 31, 2009). If you fail to remain an eligible individual during this period, you will have to include in income the total contributions made that would not have been made except for the last month rule. This amount is also subject to a 10% penalty.

Contributions may be made to an HSA by or on behalf of an eligible individual even if the individual has no compensation, or if the contributions exceed the individual's compensation. Contributions made by a family member on behalf of an eligible individual to an HSA (which are subject to the limits described above) are deductible by the eligible individual in computing adjusted gross income.

For a limited period (beginning Dec. 20, 2006, and ending December 31, 2011) an eligible individual can make a one-time transfer of amounts from a health flexible spending arrangement (health FSA) or health reimbursement arrangement (HRA) to an HSA. The amount transferred is limited to the lesser of (i) the account balance of the individual's health FSA or HRA as of September 21, 2006, or (ii) the account balance of the health FSA or HRA on the transfer date.

Similarly, on a once-only basis, taxpayers can withdraw funds from an IRA, and transfer them tax-free to an HSA. The amount transferred can be up to the maximum deductible HSA contribution for the type of coverage (individual or family) in effect at the time of the transfer. The amount so transferred is excluded from the taxpayer's gross income, and is not subject to the 10% early withdrawal penalty.

If the HSA is set up properly, it is generally exempt from taxation, and there is no tax on earnings. However, taxes may apply if contribution limitations are exceeded, required reports are not provided, or prohibited transactions occur.

Distributions from the HSA to cover an eligible individual's qualified medical expenses, or those of his spouse or dependents, are not taxed. Qualified medical expenses for these purposes generally mean those that would qualify for the medical expense itemized deduction. If funds are withdrawn from the HSA for other reasons, the withdrawal is taxable. Additionally, an extra 10% tax will apply to the withdrawal, unless it is made after reaching age 65, or in the event of death or disability.

Distributions from an HSA exclusively to pay for qualified medical expenses are excludable from the gross income of the account beneficiary even though the beneficiary is no longer an “eligible individual,” e.g., the individual is over age 65 and entitled to Medicare benefits, or no longer has a high deductible health plan.

As you can see, HSAs offer a very flexible option for providing health care coverage, but the rules are somewhat involved.

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