Tax Benefits of Opening a Health Savings Account

Taxpayers looking to enjoy a more hefty medical deduction next tax season should consider opening a health savings account.

These accounts, commonly referred to as HSAs, are tax-advantaged medical savings accounts and were  created to encourage people to save for future health problems, but there are other reasons to open such an account.

Almost all taxpayers lose part--if not all--of the medical deduction on their income taxes. In order to enjoy the writeoff you must be able to itemize deductions, but even then your medical deductions are subject to a 7.5% haircut of your adjusted gross income. It works like this: Say your adjusted gross income is $100,000, you would need more than $7,500 in medical deductions to enjoy any deduction whatsoever. The first $7,500 you spend is not eligible to be deducted.

Wouldn’t it be nice to be able to take the deduction above the line? At least part of it, anyway? Well, you can. Beginning in December 2003, Health Savings Accounts were approved by Congress for individuals and families enrolled in high-deductible health plans. You are not eligible if you are enrolled in Medicare or if you can be claimed as a dependent on someone else’s tax return. HSA plans replaced the old Medical Savings Accounts (MSA).

You cannot just open a savings account and call it an HSA. The HSA must be opened through a trustee such as a bank or an insurance company, and you can use a provider that is different than your health insurance company. Check to see if your work offers a plan, if so, perhaps your employer will make pre-tax contributions to the plan on your behalf.

To qualify as being enrolled in a high-deductible health plan (HDHP), your health insurance must have a deductible of at least $1,200 per year if you are single and $2,400 per year for family coverage. The maximum annual deductible and other out-of-pocket expenses for HDHPs are $6,050 for singles and $12,100 for family coverage.

Once you have set up an HSA, make a contribution to it. If you are single, for 2012, you may contribute up to $3,100, and if you have family coverage you may contribute up to $6,250. If your employer makes pre-tax contributions on your behalf, you must reduce your payment by the amounts from your employer.

All contributions for the year must be made by the due date of the tax return, and don’t include extensions. This means that you have until April 15, 2013 to make a contribution to be credited to 2012. You take the deduction for your contribution on page one of Form 1040 under adjustments to income.  So rather than suffering the 7.5% haircut you enjoy the full benefit of the amount you paid into the plan. All medical expenses paid from the HSA cannot be included on Schedule A, Itemized Deductions .

You will receive a debit card and/or checks to pay for your qualified medical expenses from the HSA.  Any medical expense that is allowable as a deduction on Schedule A can be paid for from your HSA account. Note that over-the-counter drugs (unless your doctor writes a prescription for them) do not qualify, however, insulin is eligible to be deducted.

Any interest earned on the HSA account is tax-free and does not have to be reported to the IRS.

At year end, you will receive a 1099 showing the amounts of distributions taken from the HSA. Provide this document to your tax preparer and indicate whether or not any of the distributions were for anything other than qualified medical expenses. Any distributions for non medical expenses are included in income in your tax return.

Please note that if you make excess contributions to your HSA, you will be subject to a 6% excise tax. For more information on HSAs consult this publication on the IRS website: Health Savings Accounts.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.