Health savings accounts gain in popularity / They're a great way to save on federal taxes, but state treatments differ widely

Darla Mercado for InvestmentNews.com writes: Tax-advantaged saving on a federal level is bolstering the popularity of health savings accounts, but clients ought to know that those attributes don't always apply from a state income tax perspective.

Health savings accounts, the investment account that typically accompanies high-deductible health plans, are enjoying a boost: In 2013, some 7.2 million people had HSAs, up from 6.6 million in 2012, according to the Employee Benefit Research Institute. During that period, assets also leapt, reaching $16.6 billion in 2013, up from $11.3 billion in the previous year.

HSAs typically run in tandem with a high-deductible health care plan, with the intention that insured people tap the HSA itself to cover qualified medical expenses. Employers and insurers generally like HSAs because insured people are using the account to foot the bill for services until they hit their deductible. In theory, if employees are aware of the real cost of medical services because they are shelling out for those expenses, they'll become more educated consumers, according to Paul Fronstin, senior research associate at EBRI.

Employers and employees can contribute to HSAs, and the chief benefit is that the funds contributed won't be subject to federal income taxes when deposited. Any distributions made for qualified medical expenses can be made without incurring taxes. Any part of a distribution that doesn't go toward these expenses counts toward gross income and will face an additional 20% levy.

In 2014, annual HSA contributions for both employers and employees are capped at $3,300 for individuals and $6,550 for families. Those over 55 can make an HSA catch-up contribution of up to $1,000. Minimum deductibles for high-deductible health care plans, meanwhile, are at $1,250 for individuals and $2,500 for families.

Further, money saved in an HSA can be carried over to the following year.

With the proliferation of HSAs, advisers and clients ought to be aware of their state's treatment of the vehicles. Three states — Alabama, California and New Jersey — treat contributions to HSAs as income for tax purposes: .

HSAs via high-deductible health plans aren't commonplace yet in Alabama, as many employers get coverage through Blue Cross Blue Shield, according to Jimmy Williamson, an accountant at MDA Professional Group PC. But he expects that landscape to change thanks to health care reform — and that will help high-deductible plans and HSAs proliferate.

“The employer mandate [to provide health care coverage] has been pushed back to 2015, but as that year comes about, we'll see more HSAs and high-deductible plans,” Mr. Williamson said.

In Alabama, the top individual income tax rate is only at 5%, so once the plans become popular, having HSA contributions subject to state income taxes likely won't deter employees from saving, Mr. Williamson added.

In New Jersey, though workers will have to count their contributions as part of their income, they can still be eligible for deductions on the amount they paid out of pocket for unreimbursed medical expenses — as long as the amount exceeds 2% of adjusted gross income — according to V. Peter Traphagen Jr., a partner at Traphagen Financial Group.

“Many employees in New Jersey can pick up the tax deduction,” he said. “You have to do some bookkeeping and due diligence, but it's well worth the savings.” The firm is actively encouraging clients to use the plans, as the federal tax benefits outweigh the fact that the contributions count toward income in the Garden State.

Finally, in California, contributions to HSAs will mean higher wages reported on state tax forms. There, clients fill out CA Form 540 and Schedule CA to spell out the differences between wages for state and federal purposes, according to Mary Kay Foss, an accountant with Sweeney Kovar.

As in other states, distributions from the HSA are reported on Form 8889 for federal purposes, and the taxpayer puts in the amount of unreimbursed medical expenses for which the distributions were used. In California, however, those medical expenses count as an additional deduction as long as they are in excess of the Schedule A limitation on the federal return, according to Ms. Foss.

In the Golden State, if the HSA earns dividends or interest, these are tax free on a federal basis, but need to be reported on state tax returns, she added.

Again, determining the best course of action for using an HSA comes down to weighing the benefits from a federal income tax planning perspective. The accounts constitute a brilliant retirement savings vehicle, since they can act as a pool for medical costs years later. “You have a pool of money that you can use tax free; you can save it and get reimbursed for medical expenses down the road,” said Monica Rebella, an accountant at Rebella Accountancy Corp.

Nevertheless, she warned that clients ought to dig into the details of their coverage before opting for the HSA. “Some people find out that certain prescription costs go up tremendously when you take the HSA versus full insurance coverage,” Ms. Rebella said. “You have to figure out how that [election] is affecting your family.”