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So, we’ve done it. We passed the four requirements to qualify for a health savings account test and are now what the Internal Revenue Service calls an “eligible individual”. We qualify for a health savings account and can officially make contributions.
The IRS throws this term “eligible individual” around more than 50 times in publication 969, so you will see me start using it more around here.
This is where things all start coming together. The moment we have been waiting for; health savings account contributions. These contributions reduce our taxable income which will start saving us some serious money on taxes. We can then use those sheltered tax dollars and put them towards our health. Time to plow some money into our account, crack a beer, and celebrate, right?
Not so fast.
It seems to me that making contributions to the health savings account would be the easy part. Unfortunately, that’s just not the case. Dumping $100,000 of tax-free income into one of these accounts over a single year is not an option. There are contribution limits and rules to follow. Life events like marriage, new jobs, or medical insurance changes can impact our annual contribution limits.
I suppose in some ways, the Internal Revenue Service (IRS) tries to keep this simple. In other ways, they seem to make it more complicated than it needs to be.
Self-Only vs. Family Coverage
The IRS carves high deductible health plan coverage out into two categories: self-only and family. They then use these categories to decide how much of our income we can contribute to our tax-free health savings account each year. So, the first thing we need to know is which category we fall into.
I like this simplified approach. I remember being briefly confused when I married Mrs. Max OOP. Confused not so much about the marriage, but whether or not I could make the full family contribution. Since we did not have kids and I was only carrying her on my HDHP, I was wondering if we met the definition of a “family”.
We could, and it doubled our contribution limit the next year. We had a cake to celebrate.
Once you are married and covering your spouse on an HDHP, the health savings account rules consider you a family even if you do not have any children. The IRS specifically calls this out.
Self-only HDHP coverage is HDHP coverage for only an eligible individual. Family HDHP coverage is HDHP coverage for an eligible individual and at least one other individual (whether or not that individual is an eligible individual). Example: An eligible individual and his dependent child are covered under an “employee plus one” HDHP offered by the individual’s employer. This is family HDHP coverage.Publication 969
Told you they like to use the term “eligible individual”.
Since my HDHP covers me (an eligible individual) and Mrs. Max OOP (at least one other individual), we have family HDHP coverage.
Once you know if you have self-only or family high deductible health plan coverage, you know your annual contribution limit.
Max will start with the basics. What is my contribution limit if I am covered by the same high deductible health plan all year?
In 2020, if you have self-only HDHP coverage all year, you can contribute $3,550 to a health savings account. If you have family HDHP coverage we double it, allowing $7,100 in annual contributions.
In 2021, the self-only contribution limits are increasing to $3,600 and the family limits will hit $7,200.
We can make extra contributions if the eligible individual happens to be over the age of 55 by the end of our tax year. In this situation, we can tack on $1,000 to the numbers above. This add-on is the same for both self-only and family coverage, it isn’t doubled for family coverage.
Again, every dollar we put into this account reduces our taxable income by a dollar. Since the Max Out of Pocket crew is covered under family HDHP coverage, we are eligible for $7,100 in contributions for 2020.
Here they are for 2020:
Those transactions will reduce my taxable income by $7,100.
As you can see, I make our contributions quarterly. There are a few reasons I go this route, and I will cover those later. We technically have until April 15th of the next calendar year to finalize contributions for the prior year, but I usually recommend completing them through payroll by December 31st.
Partial Year Contribution
This is where things get a little confusing. What if a lose my “eligible individual” status partway through the year? In other words, what if I fail one of the four eligibility requirements at some point in the year?
Maybe I am only covered by a high deductible health plan for the first three months of the year. Or, maybe I switch to an employer who does not offer a high deductible health plan with a health savings account. Or, maybe I qualify for Medicare in the middle of the year.
To make things simple, I consider contributions more of a monthly exercise than an annual contribution. For me, this decision is made on the 1st of each month. I look at the four eligibility requirements on the 1st of the month, and if I meet those requirements, I can contribute that month. I just divide the annual contribution by 12.
Medicare as an Example
As I mentioned, I will become eligible for Medicare on October 1st in the 2040s. This will make me ineligible to make a health savings account contribution that month. The same goes for November 1st, December 1st, and every month thereafter. I will fail at requirement two and three.
- You must be covered under a high deductible health plan
- You cannot have any other health coverage
- You cannot be enrolled in Medicare
- You cannot be claimed as a dependent on someone else’s return
But on the 1st of the nine months prior to October, I will be eligible for contribution. So, if I became eligible for Medicare in 2021, I would only be allowed 9 monthly contributions that year.
($7,200 / 12 Months) X 9 Eligible Months = $5,400 Contribution Limit for 2021
The IRS does the math like this for some reason:
($7,200 X 9 Eligible Months) / 12 Months = $5,400 Contribution Limit for 2021
Evidently, they think through math problems differently than me, but you get the same answer.
This is where the IRS tries to simplify things a bit. They call it the “last-month” rule. I think this is a little-known trick for those who pick up high deductible health plan coverage late in the year. I may even dedicate an entire post to this later to give it the attention it deserves.
Under this rule, if you are an eligible individual on the last month of your tax year (for most of us that is December 1st), you are considered an eligible individual for the entire year. In other words, you are treated as having the same HDHP coverage for the entire year as you had on 12/1, even if you didn’t have any coverage at all.
So, if you had family HDHP coverage on the first day of the last month of your tax year, your contribution limit for 2021 is $7,200 no matter what. That one month of coverage can reduce your taxable income by $7,200 dollars. That’s huge.
There is a catch, though. You need to remain an eligible individual for the next 12 months, and the IRS does test this. If you happen to become ineligible for HDHP coverage before 12 months go by, you must report the prior year’s health savings contribution back to the IRS as income and pay a 10% penalty. Ouch. We can touch more on this later; just be careful here.
Overall, the annual contribution limits are straightforward. Partial year coverage early in the year can get a little confusing and might require some math. But if you are lucky enough to be considered an eligible individual on December 1st and maintain that coverage for at least 12 months, your life just got a lot simpler.
Reducing your taxable income by $3,600 to $7,200 is significant. It can defer and even shelter a huge amount of tax. But how much is it worth? We will get to that, next time, here at Max Out of Pocket.
Ready for the next post in this series?
Have you taken advantage of the last-month rule? Did you know about it?
I am not a tax professional and this is not a recommendation to open a health savings account or enroll in a high-deductible health plan.