Unwary older workers can face tax penalties
for funding an HSA after 65
A colleague recently told me he had enrolled
in Medicare Part A hospital insurance when he turned 65 even though he
continues to have group health insurance coverage through our employer. Why not
enroll, he asked. Medicare Part A is premium-free. There's no downside to the
added coverage at no additional cost, right?
Not quite.
Although you can continue to take tax-free
distributions from a health savings account for qualified medical expenses at
any age, you can no longer make tax-deductible contributions to an HSA for up
to six months before you enroll in Medicare. It's an increasingly common
dilemma for people who continue to work past
age 65 when they first become eligible for Medicare.
HSAs offer a triple tax break when
paired with a high-deductible health insurance plan. Contributions are
tax-deductible, savings grow tax-free and distributions are tax-free when used
to pay for qualified medical expenses during your working years and beyond.
Stockpiling tax-free HSA funds can be a great
way to minimize future income taxes, and in some cases, reduce income-based Medicare
premiums in retirement.
Normally, you must enroll in Medicare during
the seven-month initial enrollment period that begins three months before your
65th birthday or face lifelong delayed enrollment penalties.
The only exception is if you continue to be
covered by group health insurance policy from your current employer or your
spouse's current employer. Group health insurance must cover 20 or more workers
to qualify for the exception. Retiree health benefits don't count as creditable
insurance for Medicare purposes.
Many older workers, like my colleague, prefer
to delay enrolling in Medicare penalty-free while they have group health
insurance at work so they can keep funding their HSAs. In 2020, individuals can
contribute up to $3,550 to an HSA or up to $7,100 for family coverage. In
addition, individuals age 55 and older can contribute an extra $1,000 in
catch-up contributions next year.
Once they retire, they can use their HSA funds
tax-free to pay for all qualified out-of-pocket expenses not reimbursed by
other insurance, such as deductibles, copays and co-insurance, dental and
vision expenses, insulin and diabetic supplies, over-the counter drug costs and
prescription medicines. They can also use HSA funds tax-free to pay for both
Medicare Part B and Part D premiums, but not for supplemental Medigap premiums.
The big gotcha for older workers is Medicare's
six-month retroactive rule.
Individuals who are receiving Social Security
benefits will be automatically enrolled in Medicare Part A and B upon turning
65. Those not receiving Social Security must take steps to enroll in Medicare
when they are first eligible or when their employer health insurance ends. They
should stop contributing to an HSA up to six months prior to enrolling in
Medicare, according to Center for Medicare Advocacy, as the Internal Revenue
Service will consider an individual to have had Medicare coverage during those
retroactive months.
The Center for Medicare Advocacy offered the
following example: If you turn 65 in March 2020 and plan to retire in June
2020, you should stop contributing to your HSA in February 2020, the last month
before your Medicare eligibility begins. Or if you turned 65 in March 2019 but
don't plan to retire until July 2020, you should stop contributing to your HSA
in December 2019, six months before your employer-provided group health
insurance ends and your retroactive Medicare eligibility period begins.
So what's the big deal? Ralph Coppola, a
financial adviser with Ivy Wealth Management in Rhode Island, said he couldn't
find any details on the amount of the potential penalty and how it would be
applied.
"Medicare beneficiaries who continue to
contribute funds to an HSA may face IRS penalties including payment of back
taxes on their tax-free contributions and account interest, excise taxes and
additional income taxes," according to the center's excellent article
on HSAs and Medicare beneficiaries.
"Individuals have no recourse to contest
the penalties after they've been imposed by the IRS," the center added.
"However, steps can be taken to prevent penalties for ineligible
contributions."
An individual beneficiary can withdraw any
contribution made while ineligible for an HSA without penalty if they withdraw
the contribution by the due date of the tax return for the year the
contributions were made and withdraw any income earned on the withdrawn
contributions and include the earnings on their tax return.
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