How Does the IRS Know What You Spend HSA On?

A Health Savings Account (HSA) offers a tax-advantaged way to save for future medical expenses while paired with a high-deductible health plan (HDHP). These accounts provide a triple tax benefit: contributions are tax-deductible, earnings grow tax-free, and withdrawals for qualified medical expenses are also tax-free. Understanding how the IRS monitors distributions from these accounts is important for compliance and avoiding penalties. This article outlines the IRS’s tracking mechanisms and taxpayer responsibilities for substantiating distributions.

Understanding Qualified Medical Expenses

HSA distributions are tax-free only when used for qualified medical expenses. The IRS defines these as costs for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for affecting any structure or function of the body. This includes services and products such as doctor visits, prescription medications, dental care, and vision care. Certain over-the-counter medications and menstrual care products also qualify.

Premiums for long-term care insurance, COBRA health coverage, and Medicare Parts A, B, or D can also be considered qualified medical expenses. However, expenses for general health and wellness, like gym memberships or special diets not directly tied to a specific medical condition, generally do not qualify. If HSA funds are used for expenses that do not meet these IRS criteria, the distribution becomes taxable income and incurs a penalty.

Reporting HSA Distributions

Your HSA custodian, such as a bank or brokerage firm, reports all distributions from your HSA to both you and the IRS. This reporting occurs on Form 1099-SA, “Distributions From an HSA.” This form details the gross amount distributed from your account during the year.

As the taxpayer, you have a corresponding responsibility to report your HSA activity on your annual tax return. This is done using Form 8889, “Health Savings Accounts (HSAs),” which is filed along with your Form 1040. On Form 8889, you must report the total distributions received, as indicated on your Form 1099-SA, and then specify the portion of those distributions that were used for qualified medical expenses. Any amount distributed that was not used for qualified medical expenses will be subject to taxation and potential penalties. The IRS cross-references the information provided by the custodian on Form 1099-SA with your reporting on Form 8889 to identify any discrepancies.

Maintaining Records for HSA Distributions

While your HSA administrator reports the total amount of distributions, they do not track the specific purchases you make. Taxpayers must prove HSA distributions were used for qualified medical expenses. Therefore, maintaining records of all medical expenses paid with HSA funds is important.

These records should include receipts, invoices, and Explanation of Benefits (EOB) statements from your insurance provider that detail the services received and amounts paid. Prescription records are also important for substantiating medication purchases. It is advisable to keep these documents for at least three years from the date you file your tax return, as this is the general period the IRS has to audit a return. Proper record-keeping ensures you can substantiate your tax-free distributions in the event of an IRS inquiry.

IRS Scrutiny and Enforcement

The IRS primarily identifies potential non-compliance by comparing the distribution amounts reported by your HSA custodian on Form 1099-SA with the qualified medical expenses you claim on Form 8889. A significant difference between the total distributions and the amount reported as qualified expenses can flag an account for review. This does not mean the IRS monitors every individual transaction; rather, they focus on the aggregated amounts reported.

If a discrepancy is noted, the IRS may initiate an inquiry, typically through a correspondence audit, requesting documentation to verify the qualified nature of your distributions. If you cannot provide sufficient evidence that distributions were used for qualified medical expenses, the unsubstantiated amount will be included in your gross income. Additionally, these non-qualified distributions may be subject to a 20% penalty tax. This penalty generally applies to account holders under age 65.