The interaction between the health savings account (HSA) rules and the Medicare eligibility rules can be a tax trap for unsuspecting individuals who remain in the workforce past age 65. Medicare Part A coverage typically begins when an individual reaches age 65 and either enrolls in Social Security or independently elects to delay Social Security, but enrolls in Medicare Part A. For individuals who delay enrollment past age 65, coverage under Medicare is applied retroactively for six months (or retroactively to age 65, if earlier) upon either electing Medicare coverage or enrolling in Social Security, which automatically enrolls the individual in Medicare Part A. The concern is that an individual who is enrolled in Medicare is not eligible to make any contributions to an HSA during the period of the Medicare coverage. This can be an unwelcome surprise to employers and employees who delay Medicare enrollment past age 65 and are participating in employer-sponsored HSA coverage at retirement.
The IRS recently advised in an information letter (Number 2016-0082) that there are no exceptions to this HSA eligibility rule even though the Medicare coverage giving rise to the loss of HSA eligibility is applied retroactively. Employers and employees considering Medicare coverage should be aware of the issue and where possible adjust HSA contributions accordingly. Since many employers allow employees to make pre-tax HSA contributions through a cafeteria plan, mid-year changes may not be permitted or practical and employers likely would not have six months’ advance notice that an employee is retiring or planning to enroll in Medicare. Thus, in most cases, the individual HSA holder will need to take action to ensure the contributions are returned or otherwise withdrawn prior to the individual’s tax return deadline for the year (or years) in which the ineligible HSA contributions are made to avoid a six percent excise tax.
In some cases, an individual may not know that there is an HSA eligibility issue in time to correct the problem. For example, an individual electing to enroll in Medicare after age 65 in May 2017 will have coverage under Medicare applied retroactively to November 2016. If the employee was enrolled in an HSA in 2016, there would be at least two months in which excess contributions could have occurred, but the tax return deadline for returning those contributions without payment of the excise tax has already passed (unless the individual obtained an extension for filing the return). The good news is that all HSA withdrawals after reaching the age for Medicare eligibility are exempt from the 20 percent penalty that normally applies if the funds are not used for qualifying medical expenses. Irrespective of penalties and excise taxes, amounts withdrawn from the HSA must be included in the individual’s taxable income for the year of withdrawal.
The decision about when to enroll in Medicare for employees working past age 65 can impact not only HSA eligibility, but the COBRA rights of spouses covered under an employer’s group health plan, for example, and certain rights under Medicare. Too often, these issues are not addressed until after the election to enroll in Medicare, when it is too late for a correction. With more and more employees remaining in the workforce past age 65, employers and their advisors should become familiar with the issues so that they know when to advise aging and retiring employees to seek professional guidance with respect to the appropriate steps to take in deciding when to enroll in Medicare.
IRS Circular 230 Disclosure: We inform you that any U.S. federal tax advice contained in this communication (including any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed therein. (The foregoing disclaimer has been affixed pursuant to U.S. Treasury regulations governing tax practitioners.)
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