Keep HSA Debit Card Transactions from Becoming Prohibited Transactions
More often than not, financial organizations that offer a health savings account (HSA) provide their HSA clients with an HSA debit or credit card. This is a convenient way for clients to withdraw money from their account, as most HSA owners use their HSA to pay for medical expenses, resulting in frequent distributions throughout the year. While a card gives them easier access to their HSA funds, it can also put the HSA at risk for a prohibited transaction. Fortunately, there are simple ways to avoid this risk.
How a Prohibited Transaction May Occur
First, organizations should understand why an HSA that has a debit or credit card is at risk. Like IRAs, HSAs are subject to the prohibited transaction rules under Internal Revenue Code Section (IRC Sec.) 4975, which, among other things, states that creating a loan or credit obligation in the account is not allowed. Thus, a prohibited transaction may occur if the debit or credit card withdrawal causes an extension of credit to the HSA owner. For example, to prevent an overdraft of an HSA, some organizations automatically cover transactions that exceed the HSA owner’s balance. This results in a loan or credit obligation to the HSA itself (essentially, the HSA has a negative balance). Both the Department of Labor and the Department of the Treasury may view this as a prohibited transaction under IRC Sec. 4975.
If an extension of credit occurs within an HSA, the HSA becomes disqualified and ceases to be an HSA as of January 1 of the year in which the prohibited transaction occurred. The assets are then deemed distributed and subject to tax and the 20 percent penalty tax for nonqualified distributions.
How to Avoid a Prohibited Transaction
The IRS has not directly addressed in any formal written guidance how to avoid an extension of credit in an HSA. Until it does, a financial organization should have its own policy in place for avoiding a potential prohibited transaction. The organization may want to consider incorporating one of the following methods as its policy for preventing an extension of credit. Note that in each case, the HSA owner must have an agreement in place with the financial organization authorizing the transactions.
Method 1: Automatic Draw From Non-HSA
One method is to draw money from another of the HSA owner’s accounts once the HSA balance hits $0 if the debit or credit card is used. This prevents the HSA balance from dropping below $0, thereby preventing an extension of credit and avoiding a prohibited transaction.
Example: Vera has two accounts at Isle of Wight Bank: an HSA and a regular savings account. She has $500 in her HSA and $500 in her savings account. At the hospital, Vera authorizes a debit card transaction from her HSA of $1,000. To prevent an extension of credit, upon receipt of the transaction, Isle of Wight Bank draws $500 from Vera’s HSA and $500 from her savings account, in accordance with the existing agreement between it and Vera. The $500 taken from Vera’s savings account is not treated as an HSA contribution, because it is paid directly from the savings account to the hospital.
Method 2: Automatic HSA Contribution
A second method that may be used is similar to the first, but different in that instead of paying the hospital directly from the savings account, an amount is moved from the savings account into the HSA as a contribution. The full amount is then paid from the HSA.
Example: Chuck has two accounts at Isle of Wight Bank – an HSA and a regular savings account. He has $500 in each account. Chuck authorizes a debit card transaction from his HSA of $1,000. To prevent an extension of credit, upon receipt of the transaction, Isle of Wight Bank takes $500 from Chuck’s savings account and moves it to his HSA. The full $1,000 is now in the HSA, so the balance will not drop below $0. The $500 taken from Chuck’s savings account is treated as an HSA contribution because it is moved from the savings account to the HSA.
Caution should be taken in this scenario to avoid creating an excess in the HSA.
Method 3: HSA Distribution Moved to Medical Expense Checking Account
A third possible method that may be used is essentially the opposite of the second. Instead of moving money from a non-HSA account to the HSA, money can be moved from the HSA to the non-HSA account if expenses are incurred in a non-HSA account.
Example: Dave has an HSA with a non-HSA checking account tied to it at Isle of Wight Bank. Dave pays $1,000 in medical expenses with his non-HSA checking account. Upon receipt of the transaction, Isle of Wight Bank moves $1,000 from Dave’s HSA into his non-HSA checking account. The $1,000 is reported as a distribution from the HSA.
Prevention, Prevention, Prevention
In the absence of direct IRS guidance, the only sure way to avoid an extension of credit, and therefore a prohibited transaction, is to prevent the HSA from incurring debit or credit card-generated debt. One option is to deny distributions when HSA balances are exceeded. The other is to create obligations outside of the HSA, using one of the three methods detailed above.