Are You Taxed on HSA Distributions?

Health Savings Accounts (HSAs) serve as a tax-advantaged savings mechanism for healthcare costs. These accounts offer tax benefits on contributions, earnings, and distributions. Withdrawals from an HSA are generally not taxed if used for qualified medical expenses. However, if distributions are used for non-qualified expenses, they may become subject to ordinary income tax and an additional penalty.

Qualified Medical Expenses

A “qualified medical expense” encompasses costs primarily for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for affecting any structure or function of the body. These expenses are defined by Internal Revenue Service (IRS) guidelines and are listed in IRS Publication 502.

Common examples of qualified medical expenses include doctor visits, prescription medications, dental care, vision care, and eligible over-the-counter medications and products. This also covers costs for equipment, supplies, and diagnostic devices necessary for medical care. Amounts paid for inpatient treatment for alcoholism or drug addiction, as well as smoking cessation programs, are also generally considered qualified.

Not all health-related expenses qualify. For instance, cosmetic procedures are not qualified medical expenses unless medically necessary to correct a deformity. General health items like vitamins or a gym membership do not qualify unless prescribed for a specific medical condition. Maintain detailed records, such as receipts and invoices, for all medical expenses paid with HSA funds. These records substantiate that distributions were used for qualified medical expenses, especially if the IRS requests documentation during an audit.

Non-Qualified Distributions and Tax Implications

Distributions from an HSA that are not used for qualified medical expenses are considered non-qualified distributions. When this occurs, the distributed funds are subject to ordinary income tax, just like regular income. This means the tax benefits enjoyed on the contributions and earnings are reversed for the non-qualified amount.

In addition to income tax, a penalty applies to non-qualified distributions taken before age 65. This penalty is 20% of the non-qualified amount withdrawn. For example, a $1,000 non-qualified withdrawal for someone under 65 would incur $200 in penalties, plus the income tax.

Once an HSA account holder reaches age 65, the 20% penalty for non-qualified distributions no longer applies. At this age, non-qualified distributions are still subject to ordinary income tax, but they are not penalized further. This treatment makes HSAs more flexible in retirement, allowing withdrawals for any purpose, though the tax-free benefit is retained only for qualified medical expenses. Exceptions to the penalty also exist for distributions due to disability or death, where only ordinary income tax may apply to non-qualified amounts.

Tax Reporting for HSA Distributions

Reporting HSA distributions accurately is a necessary step during tax season. Your HSA custodian will issue Form 1099-SA, “Distributions From an HSA, Archer MSA, or Medicare Advantage MSA,” which details all distributions made from your account during the year. This form will indicate the total amount distributed and the distribution code.

To report these distributions, you must file Form 8889, “Health Savings Accounts (HSAs),” with your federal income tax return. This form has sections to report contributions and distributions, and you will enter the total distributions from your Form 1099-SA on it. On Form 8889, you also specify the amount of distributions used for qualified medical expenses. Only the portion of distributions exceeding your qualified medical expenses will be subject to ordinary income tax and, if applicable, the 20% penalty. The IRS requires you to maintain records, such as receipts for all medical expenses, to support the amounts claimed as tax-free distributions.