Beware: Enrolling in Medicare can nix contributing to an HSA

HSAs have no annual use-it-or-lose-it requirements, and balances can be carried forward from year to year and withdrawn tax-free in retirement to pay for medical expenses, such as Medicare and long-term care premiums — but not Medigap premiums.

Special rules apply to health savings account owners when they turn 65. HSA contributions are no longer allowed once the account holder enrolls in Medicare, but distribution rules are relaxed.

HSAs offer a triple tax break: Contributions are tax-deductible, earnings grow tax-free and distributions are tax-free when used to pay for qualified medical expenses. To qualify for the tax break, an HSA must be paired with a high-deductible health plan.

HSAs have no annual use-it-or-lose-it requirements, and balances can be carried forward from year to year and withdrawn tax-free in retirement to pay for medical expenses, such as Medicare and long-term care premiums but not Medigap premiums. Think of it as a Roth IRA for your retiree medical costs.

Normally, HSA distributions used to pay for anything other than qualified medical expenses are subject to taxes and a 20% penalty. However, once an account holder turns 65 (or becomes disabled), HSA distributions can be used for anything penalty-free. But nonqualified distributions are taxable.

[More: Can HSAs flip the script on retirement health care expenses?]

Most people sign up for Medicare Part A hospital insurance, which is free, and Medicare Part B health insurance, which has a monthly premium, when they are first eligible at age 65. Those who don’t enroll when first eligible may have to pay a Part B late enrollment penalty for the rest of their lives.

There is an exception to the delayed-enrollment penalty for individuals who continue to work and are covered by their current employer’s group health insurance plan or through their spouse’s group health insurance. They do not have to enroll in Medicare at 65 and can enroll penalty-free within eight months of retiring or losing their group health insurance.

Once enrolled in Medicare, even if it is just the premium-free Part A hospital insurance, you will no longer be able to contribute to an HSA. For example, you turn 65 in July 2021 and enroll in Medicare. You have a high-deductible health plan with self-only coverage and an annual deductible of $3,600. You are also eligible for an additional catch-up contribution of $1,000 available to HSA owners age 55 and older. Your contribution limit for 2021 is $2,300 ($4,600 × 6 ÷ 12).

Beware: If you enroll in Part A at any time after you are first eligible for Medicare, your coverage will begin six months retroactively from the time you sign up (but no earlier than the first month you are eligible for Medicare). So if you delayed applying for Medicare, any funds you contributed to your HSA during the period of retroactive coverage are considered excess contributions. To avoid a tax penalty, you should stop contributing to your HSA at least six months before you apply for Medicare.

(Questions about Social Security rules? Find the answers in Mary Beth Franklin’s ebook at InvestmentNews.com/MBFebook.)