One of the benefits of a health savings account (HSA) under current law is that you can withdraw HSA funds tax-free to pay Medicare premiums, as well as other qualified medical expenses. HSA funds cannot be used to pay regular health insurance premiums, so this provision offers a tax advantage for those age 65 and older.
The catch, however, is that once you enroll in Medicare, you cannot contribute to an HSA, even if you are also covered under a high-deductible health plan (HDHP). HSA funds can be used regardless of whether you are eligible to contribute, but you would have to build substantial savings before enrolling in Medicare in order to cover premiums from your HSA throughout retirement. (HSA funds cannot be used to pay Medigap premiums.)
Spousal Solution
If you are married and your spouse is HSA-eligible, you can contribute to your spouse's HSA even if you are enrolled in Medicare. In fact, anyone can contribute to anyone else's HSA. In order to make the maximum HSA family contribution ($7,100 in 2020), you both must be covered under an HDHP for the full year; if only your spouse is covered, the individual limit applies ($3,550 in 2020). If your spouse is age 55 or older, he or she can contribute an additional $1,000, but you would not be eligible to do so.
Using this approach, some couples may be able to build more tax-advantaged savings before both spouses enroll in Medicare and lose their HSA eligibility.
Missing Out on Long-Term BenefitsAlthough HSAs offer an opportunity for long-term tax-advantaged savings and investment, two-thirds of HSA owners view their accounts as a way to pay current medical bills, while only one-third view them as a way to save for the future. This may be why HSA balances, in general, are relatively low.
Retroactive Trap
If you enroll in Medicare (or are automatically enrolled) at age 65, you lose your HSA eligibility on the first day of the month you turn 65. However, if you enroll after age 65, you will be retroactively enrolled in premium-free Medicare Part A hospital insurance for six months (or back to your 65th birthday if that is within six months), and thus will lose your HSA eligibility for that period.
Claiming Social Security benefits after age 65 automatically triggers enrollment in Medicare Part A, with the same six-month retroactive period. For example, if you file for Social Security in October 2020 when you turn age 66, you will be retroactively enrolled in Medicare Part A as of April 2020.
Without careful planning, this situation can lead to excess HSA contributions for the year. Using the example above, you would be eligible to contribute only for January, February, and March 2020— three out of 12 months — equal to one-fourth of your annual contribution limit. Any contributions beyond this would be considered excess and would be subject to income taxes and an annual 6% penalty for as long as the excess contributions and any earnings on the contributions remain in your account.
Avoiding the Penalty
You can avoid this penalty by withdrawing excess HSA contributions, and any earnings associated with them, by the due date of your tax return (including extensions) for the year the contributions were made. To do so, you must request the withdrawal from the HSA administrator.
The excess contributions should be claimed as ordinary income on your tax return for the year the contributions were made, even if you actually receive the funds in the following year. Depending on when your request is processed by the HSA administrator, the distribution may appear on Form 1099-SA for the year you requested it or the following year, so be sure to keep careful records.
The situation is even more complex when the retroactive period stretches across two tax years or affects an HSA testing period, such as for the "last-month rule" or a qualified funding distribution from an IRA to an HSA. Consult your tax professional if you have questions about how to handle excess contributions.
You cannot opt-out of Medicare Part A and receive Social Security benefits; however, you can request to waive the six-month retroactive period at the time you claim Social Security. This request must be made over the phone or at a Social Security office; you cannot do it when you apply online.
There have been multiple proposals to change the rules regarding Medicare and HSAs, so you may want to keep an eye on further developments.
HSA funds can be withdrawn free of federal income tax and penalties provided the money is spent on qualified health-care expenses. Depending on the state, HSA contributions and earnings may or may not be subject to state taxes. You cannot establish or contribute to an HSA unless you are enrolled in an HDHP; Medicare enrollment excludes you from HSA eligibility even if you are also enrolled in an HDHP.