Learn About HSA Withdrawal Rules and Options

Understanding HSA Withdrawal Rules: The Basics

A Health Savings Account (HSA) is a special savings account designed to help people pay for medical expenses. Unlike a regular savings account, an HSA comes with specific rules about when and how you can withdraw money. Understanding these rules is important because withdrawing money incorrectly can result in taxes and penalties that reduce your savings.

HSAs are only available to people who have a qualified high-deductible health insurance plan (HDHP). As of 2024, a high-deductible plan means your deductible is at least $1,600 for individual coverage or $3,200 for family coverage. The HSA rules are established by the Internal Revenue Service (IRS), which is a federal agency that oversees tax matters.

One of the key features of an HSA is that withdrawals for qualified medical expenses are not taxed. This means you can take money out to pay for approved healthcare costs without losing any of that money to income tax. However, if you withdraw money for non-medical reasons, you will owe income tax on that amount, plus an additional 20% penalty tax. This penalty applies until age 65.

The IRS maintains a detailed list of what counts as a qualified medical expense. These include doctor visits, prescription medications, dental work, vision care, mental health treatment, and many other healthcare services. The list is quite long and covers most common medical needs. However, some items like cosmetic surgery or general wellness products do not count as qualified expenses.

Many people keep their HSA for years or even decades, allowing the money to grow. Unlike flexible spending accounts (FSAs), which require you to use the money by the end of the year or lose it, HSA funds roll over year to year. This makes HSAs a powerful long-term savings tool for retirement healthcare expenses.

Practical Takeaway: Before withdrawing from your HSA, verify that your expense is on the IRS list of qualified medical expenses. Keep all receipts and documentation for at least three years in case the IRS has questions about your withdrawals.

Qualified Medical Expenses: What You Can Withdraw For

The IRS publishes a comprehensive list of qualified medical expenses that you can withdraw from your HSA without penalty or tax. This list covers most healthcare-related costs, but the rules can be detailed and sometimes surprising. Understanding what counts helps you make the most of your HSA funds.

Common qualified expenses include visits to doctors, dentists, and eye doctors. This covers regular checkups, emergency care, and specialist consultations. If your doctor prescribes medication, the cost of that medication is a qualified expense. Over-the-counter medications like aspirin or cold medicine are also covered, but you must have a prescription from your doctor to withdraw HSA funds for them. This requirement changed in recent years, so some older HSA holders may not be aware of it.

Dental care is fully covered under HSA rules. This includes regular cleanings, fillings, root canals, crowns, orthodontia, and tooth extractions. Vision care costs such as eye exams, glasses, and contact lenses are also qualified expenses. Hearing aids and hearing-related care are covered as well.

Mental health and therapy services are qualified expenses. If you see a therapist, psychiatrist, or counselor, you can pay for those services with HSA funds. Treatment for addiction, rehabilitation services, and hospitalization are also covered. Medical equipment like wheelchairs, crutches, and blood pressure monitors qualify. Insulin, even if purchased without a prescription in some states, is a qualified expense.

Some expenses that surprise people include deductibles and copayments on your health insurance, long-term care insurance premiums, and certain health insurance costs if you are unemployed. Pregnancy-related care, including prenatal vitamins and childbirth, are qualified expenses. However, general vitamins and dietary supplements are not covered unless prescribed by a doctor for a specific medical condition.

It is important to note what does NOT count. Cosmetic surgery and procedures are not covered unless they are medically necessary due to injury or disease. General wellness products, gym memberships, and over-the-counter medications without a prescription do not count. Travel expenses to receive medical care are not covered, though the medical service itself is.

Practical Takeaway: Review the IRS Publication 502 (Medical and Dental Expenses) for the complete list of qualified expenses. When in doubt about a specific expense, ask your HSA administrator or a tax professional before withdrawing funds.

Age 65 and Beyond: HSA Withdrawal Rules Change

One of the most valuable features of an HSA is that the rules change significantly when you reach age 65. At this age, you can withdraw money from your HSA for any reason without facing the 20% penalty tax. However, you will still owe income tax on non-medical withdrawals. This change makes an HSA function somewhat like a traditional Individual Retirement Account (IRA) once you turn 65.

Before age 65, if you withdraw money for non-medical reasons, you owe both income tax and a 20% penalty. For example, if you withdraw $1,000 for a non-qualified expense at age 50 and you are in the 24% tax bracket, you would owe $240 in income tax plus $200 in penalties, for a total of $440 in taxes. After age 65, that same $1,000 withdrawal would only result in $240 in income tax, with no penalty.

This age-65 rule has important planning implications. Some financial advisors suggest that people with HSAs should try to pay for medical expenses out of pocket during their working years, allowing the HSA to grow as an investment. Then, starting at age 65, they can withdraw money from the HSA for any purpose, treating it as additional retirement income. This strategy could allow your HSA to function as a supplemental retirement account.

The qualified medical expense rules do not change at age 65. If you continue to withdraw only for qualified medical expenses, you will not owe any taxes at all on those withdrawals, regardless of your age. Many retirees have significant medical expenses as they age, so they may continue using HSA funds primarily for healthcare costs.

Once you turn 65, you become eligible for Medicare. At this point, you can no longer contribute to your HSA, but you can still withdraw from it. If you have Medicare, you can still use your HSA to pay for qualified medical expenses that Medicare does not cover, such as dental work, vision care, and hearing aids. You cannot use HSA funds to pay Medicare premiums, with one exception: if you are paying for continuation coverage while unemployed (called COBRA), you can use HSA funds for those premiums.

Practical Takeaway: If you are under 65, consider how you will use your HSA strategically. Paying some medical expenses out of pocket while allowing the HSA to grow for retirement could provide valuable flexibility in later years.

Penalty Taxes and Non-Qualified Withdrawals Explained

Understanding the tax consequences of non-qualified HSA withdrawals is essential to avoiding unexpected tax bills. The penalty structure is different from other retirement accounts and includes both income tax and an additional penalty tax.

When you withdraw money from an HSA for a non-qualified expense before age 65, two taxes apply. First, you owe regular income tax on the amount withdrawn. The tax rate depends on your personal income tax bracket, which can range from 10% to 37% under current federal tax law. Second, you owe an additional 20% penalty tax on top of the income tax. This penalty is sometimes called the "additional tax" and is specifically imposed by the IRS for non-qualified HSA withdrawals.

For example, suppose you withdraw $2,500 from your HSA at age 40 to pay for a cosmetic dental procedure. If your tax bracket is 22%, you would owe $550 in income tax ($2,500 × 22%) plus $500 in penalty tax ($2,500 × 20%), for a total of $1,050 in taxes. This means only $1,450 of your original $2,500 remains available to pay the expense. In effect, the HSA withdrawal cost you significantly more than if you had simply paid for the procedure with regular income and claimed the medical deduction if applicable.

The 20% penalty does not apply after age 65.