Beware of the HSA Trap After Enrolling in Medicare

Many Americans spend years building a healthy balance in a Health Savings Account (HSA), taking advantage of one of the most tax-friendly savings vehicles available. But once Medicare enters the picture, a simple misunderstanding can create an unexpected tax headache.

Under IRS rules, once you enroll in Medicare, you are no longer eligible to contribute to an HSA, which can be used to reimburse your out-of-pocket medical expenses. These accounts are usually administered by your employer.

However, many seniors continue contributing after they sign up for Social Security, not knowing that once they do, they are automatically enrolled in Medicare Part A. Those contributions could be subject to a tax penalty of 6% on those funds.

The problem can compound if they don't realize their mistake and either continue contributing to their HSA or delay correcting it.

HSAs explained

If you have a high-deductible health plan (HDHP) through your employer or one purchased through the Affordable Care Act marketplace, you may be eligible to contribute to an HSA. Contributions are generally made with pre-tax dollars. Investment earnings may grow over time and withdrawals for qualified medical expenses are tax-free.

Funds in these accounts can be invested like a 401(k) and withdrawn to reimburse medical expenses, including copays, coinsurance, medications and certain medical equipment.

Enrollment trap

Some individuals work past age 65 and remain covered by an employer-sponsored HDHP.

The problem often arises when they begin taking Social Security benefits because, in most cases, they are automatically enrolled in Medicare Part A. Many people don't realize this enrollment has occurred.

Adding to the confusion is Medicare's retroactive coverage provision. When a person enrolls in Medicare after age 65, Medicare Part A coverage may apply retroactively for up to six months, but not before the month they first became eligible.

That six-month lookback period can create a problem for HSA contributors. Contributions made during that period may be treated as excess because the individual is considered covered by Medicare.

Tax consequences

Excess HSA contributions are subject to IRS penalties if they aren't corrected in a timely manner.

The IRS generally imposes a 6% excise tax on excess contributions. That tax can continue each year until the excess amount and any associated earnings are removed from the account and properly reported.

For someone who unknowingly continues making maximum HSA contributions for months after Medicare enrollment, the costs can add up quickly. In addition to the excise tax, they may need to amend tax returns and work with their HSA administrator to correct the error.

How to avoid problems

If you plan to enroll in Medicare or begin collecting Social Security benefits, review your HSA contribution strategy well in advance. Many financial and tax professionals recommend stopping HSA contributions at least six months before your anticipated Medicare enrollment date to avoid any issues from retroactive coverage.

If you're unsure whether you're enrolled in Medicare Part A, contact the Social Security Administration or Medicare before making additional HSA contributions.

Don't overlook the value of your HSA

While you must stop contributing once you enroll in Medicare, your HSA can remain a valuable retirement asset. A well-funded HSA can cushion the blow of higher medical expenses in your golden years.

The key is understanding the rules so you can enjoy the benefits without triggering unnecessary taxes or penalties.