When an HSA Goes Negative: Why it Matters and How to Prevent it
By Jodie Norquist, CIP, CHSP
Health savings accounts (HSAs) are designed to help people pay for qualified medical expenses, so it’s no surprise that there’s a lot of money going in and out of these accounts. To make it easier for account owners to pay for things like prescriptions or doctor visits, many financial organizations offer HSA debit cards or checks. While these tools add convenience, they can also create problems, especially when they lead to negative balances.
And there is the biggest issue: a negative balance in an HSA can cause a prohibited transaction, which has serious consequences for both the account owner and the financial organization.
When a Simple Swipe Becomes a Problem
Let’s say an HSA owner uses his debit card to pay a $100 bill, but his HSA only has $75. If your financial organization lets the transaction go through anyway, covering the $25 shortfall, you’ve essentially given a loan to the HSA. This is a problem.
Under IRS rules (specifically IRC Sec. 4975), any kind of loan or extension of credit between an HSA and the account owner (a “disqualified person”) is a prohibited transaction. Once this happens, the IRS says the HSA is no longer an HSA, starting retroactively from January 1 of that year. So even if the transaction happens in June, the IRS considers the account disqualified as of January 1.
An IRS representative has commented to Ascensus that reporting contributions and distributions during the year of the prohibited transaction should be suppressed.
What Happens Next?
When an HSA is disqualified,
it’s treated as if the full value of the account on January 1 was distributed to the account owner,
that amount is subject to income tax and a 20 percent penalty (unless the account owner is over age 65),
any contributions made after January 1 aren’t considered valid HSA contributions, and
any withdrawals made after that date aren’t qualified distributions.
Financial organizations must report the deemed distribution on IRS Form 1099-SA, Distributions From an HSA, Archer MSA, or Medicare Advantage MSA. It is reported as a prohibited transaction with the January 1 fair market value (FMV) in Box 1, Gross distribution, and distribution code 5, Prohibited transaction, in Box 3, Distribution code. If the FMV on January 1 in the applicable year is zero, the financial organization will enter zero (-0-) in Box 1 (and code 5 in Box 3).
Additionally, the deemed distribution on January 1 is considered a nonqualified distribution for the HSA owner and—as noted above—is subject to ordinary income taxation and a 20 percent penalty tax, unless the account owner is age 65 or older. An HSA owner may have to adjust his tax return if he has already filed it for the applicable year.
Unfortunately, there is no grace period to fix the negative balance, and no minimum threshold that escapes these rules. Even a small overdraft counts.
A negative HSA balance only disqualifies that specific HSA. In other words, it does not affect any other HSAs that the individual or her spouse may own. But once disqualified, no new contributions (neither employer nor personal) can be made to that particular HSA. It doesn’t prevent the individual from opening another HSA.
How Can Financial Organizations Prevent Prohibited Transactions?
So what can you do to prevent a prohibited transaction in an HSA? Because IRS guidance on this issue is limited, financial organizations are taking different approaches to prevent negative HSA balances.
1. Block transactions that exceed the HSA balance. Some organizations set up a flag in their system to reject debit card or check transactions once the HSA balance hits zero, or a set minimum balance, such as $25.
2. Create linked account arrangements. Financial organizations can let clients link their HSA to another account, such as a checking or savings account, to automatically cover transactions that would otherwise overdraw the HSA. Terms should be spelled out in writing for account owners. Here are a few ways that could work.
Split the payment between accounts. If a $900 qualified medical expense comes through but the HSA has only $500, the remaining $400 can be pulled from a linked savings account. The $500 would be reported as an HSA distribution.
Move funds into the HSA first. Another option is to move $400 into the HSA before making the $900 payment. But this can become a problem. The $400 must be treated as an HSA contribution and if the account owner has already met his annual contribution limit, or is ineligible for a new contribution, it could become an excess contribution.
Use a non-HSA account exclusively. Some organizations set up non-HSA checking accounts specifically for medical expenses. They move money from the HSA into the non-HSA account and pay bills from there. Each withdrawal from the HSA is reported as a distribution.
The Bottom Line
Ultimately, it’s important that HSA owners understand the consequences of a negative HSA balance; after all, it’s their account and their responsibility. Financial organizations should educate them and consider systems that prevent HSAs from negative balances. The goal is to make sure HSAs continue to serve their purpose, helping people pay for health care tax- and penalty-free.
