Medicare and health savings accounts don't mix

A colleague recently told me he had enrolled in Medicare Part A hospital insurance when he turned 65 even though he continues to have group health insurance coverage through our employer. Why not enroll, he asked. Medicare Part A is premium-free. There's no downside to the added coverage at no additional cost, right?

Not quite.

Although you can continue to take tax-free distributions from a health savings account for qualified medical expenses at any age, you can no longer make tax-deductible contributions to an HSA for up to six months before you enroll in Medicare. It's an increasingly common dilemma for people who continue to work past age 65 when they first become eligible for Medicare.

HSAs offer a triple tax break when paired with a high-deductible health insurance plan. Contributions are tax-deductible, savings grow tax-free and distributions are tax-free when used to pay for qualified medical expenses during your working years and beyond.

Stockpiling tax-free HSA funds can be a great way to minimize future income taxes, and in some cases, reduce income-based Medicare premiums in retirement.

Normally, you must enroll in Medicare during the seven-month initial enrollment period that begins three months before your 65th birthday or face lifelong delayed enrollment penalties.

The only exception is if you continue to be covered by group health insurance policy from your current employer or your spouse's current employer. Group health insurance must cover 20 or more workers to qualify for the exception. Retiree health benefits don't count as creditable insurance for Medicare purposes.

Many older workers, like my colleague, prefer to delay enrolling in Medicare penalty-free while they have group health insurance at work so they can keep funding their HSAs. In 2020, individuals can contribute up to $3,550 to an HSA or up to $7,100 for family coverage. In addition, individuals age 55 and older can contribute an extra $1,000 in catch-up contributions next year.

Once they retire, they can use their HSA funds tax-free to pay for all qualified out-of-pocket expenses not reimbursed by other insurance, such as deductibles, copays and co-insurance, dental and vision expenses, insulin and diabetic supplies, over-the counter drug costs and prescription medicines. They can also use HSA funds tax-free to pay for both Medicare Part B and Part D premiums, but not for supplemental Medigap premiums.

The big gotcha for older workers is Medicare's six-month retroactive rule.

Individuals who are receiving Social Security benefits will be automatically enrolled in Medicare Part A and B upon turning 65. Those not receiving Social Security must take steps to enroll in Medicare when they are first eligible or when their employer health insurance ends. They should stop contributing to an HSA up to six months prior to enrolling in Medicare, according to Center for Medicare Advocacy, as the Internal Revenue Service will consider an individual to have had Medicare coverage during those retroactive months.

The Center for Medicare Advocacy offered the following example: If you turn 65 in March 2020 and plan to retire in June 2020, you should stop contributing to your HSA in February 2020, the last month before your Medicare eligibility begins. Or if you turned 65 in March 2019 but don't plan to retire until July 2020, you should stop contributing to your HSA in December 2019, six months before your employer-provided group health insurance ends and your retroactive Medicare eligibility period begins.

So what's the big deal? Ralph Coppola, a financial adviser with Ivy Wealth Management in Rhode Island, said he couldn't find any details on the amount of the potential penalty and how it would be applied.

"Medicare beneficiaries who continue to contribute funds to an HSA may face IRS penalties including payment of back taxes on their tax-free contributions and account interest, excise taxes and additional income taxes," according to the center's excellent article on HSAs and Medicare beneficiaries.

​Read more: How to maximize HSA and Medicare benefits

"Individuals have no recourse to contest the penalties after they've been imposed by the IRS," the center added. "However, steps can be taken to prevent penalties for ineligible contributions."

An individual beneficiary can withdraw any contribution made while ineligible for an HSA without penalty if they withdraw the contribution by the due date of the tax return for the year the contributions were made and withdraw any income earned on the withdrawn contributions and include the earnings on their tax return.