**Question: **What rules apply to reimbursing medical expenses from an HSA in subsequent years?

**Short Answer: **Individuals can maximize the triple-tax advantaged status of their HSA funds by delaying reimbursement of medical expenses for multiple years.  Individuals must keep sufficient records of such expenses, which is why the concept is frequently referred to as the “shoebox rule”—a reference to storing medical receipts in a shoebox for multiple years.

General Rule: HSAs are Triple-Tax Advantaged

HSAs offer an unparalleled three tiers of federal tax savings:

• Pre-Tax Contributions

• Employee contributions through payroll are made on a pre-tax basis through the Section 125 cafeteria plan.

• Employee contributions outside of payroll receive an above-the-line tax deduction.

• Employer contributions are tax-free to the employee.

• Tax-Free Growth

• HSA gains are not subject to interest, dividend or capital gains taxes.

• Tax-Free Distributors

• Distributions for qualifying medical expenses are not subject to taxation.

Additional Notes:

• California and New Jersey do not conform to the federal tax-advantaged treatment of HSAs for state income tax purpose.  For more details, see our prior post: California and New Jersey HSA State Income Tax.

• Non-medical distributions are subject to ordinary income taxes at all ages, and they are also subject to a 20% additional tax for individuals who are under age 65.  For more details, see our prior post: Using an HSA for Non-Medical Expenses.

• Employer tax-free and employee pre-tax contributions through payroll also avoid FICA taxes, providing an additional 7.65% of savings on top of the income tax savings.

• For more details on everything HSA, see our Newfront Go All the Way With HSA Guide.

Save It Forward: The HSA Shoebox Rule

HSAs offer an additional unique feature to further enhance its triple-tax advantaged status—the ability to delay taking a tax-free medical distribution for years while enjoying the tax-free growth.  There is no requirement that a tax-free HSA medical distribution be taken in the same year that the medical expense was incurred.

IRS guidance confirms that as long as the requirements are followed, “there is no time limit on when the distribution must occur.”  (IRS Notice 2004-50, Q/A-39).

This concept of saving medical receipts for HSA distributions taken in future years is commonly referred to as the “shoebox rule,” in reference to the use of a shoebox for the safekeeping of such records.

The HSA Shoebox Rule Requirements:

• The expense was incurred after the HSA was established;

• The individual keeps records sufficient to later show that the distributions were exclusively to pay or reimburse qualified medical expenses;

• The qualified medical expenses have not been previously paid or reimbursed from another source; and

• The medical expenses have not been taken as an itemized deduction in any prior taxable year.

Example 1:

• Phil has established his HSA prior to 2021.

• He incurs $1,400 in expenses for the deductible in his 2021 HDHP.

• Phil also pays $600 out-of-pocket (i.e., not covered by insurance or reimbursed by any account) in 2021 for new prescription glasses and the cost-sharing for a new dental crown.

• He does not take any of these expenses as an itemized deduction.

• He does not pay for any of these expenses directly from his HSA, preferring instead to receive credit card reward points.

• Phil keeps the records of his $2,000 of medical expenses incurred in 2021 safely stored in a shoebox.

Result 1:

• Phil can take a $2,000 distribution from his HSA in 2021 to reimburse himself for the medical expenses he incurred that year.

• Phil could instead choose to wait until a later year, such as 2026, 2035, 2050, etc., to reimburse himself for the $2,000 in medical expenses he incurred in 2021.

• Delaying reimbursement for multiple years provides additional opportunity for the tax-free growth of Phil’s HSA funds (invested in stock/bond mutual funds through his HSA custodian).

Additional Notes:

• Establishment of the HSA generally requires that the HSA be funded.  For more details, see our prior post: HSA Establishment Date.

Bonus: Loss of HSA Eligibility Does Not Affect Ability to Take Tax-Free Medical Distributions

Individuals do not have to maintain HSA eligibility (i.e., the ability to make or receive HSA contributions) to take tax-free distributions for medical expenses.

This means an HSA owner can:

1. Build up an HSA balance, move to non-HDHP coverage in a subsequent year, and still use that HSA (after losing HSA eligibility) to cover qualifying medical expenses tax-free; and/or

2. Incur but not reimburse qualifying expenses while HSA-eligible, move to non-HDHP coverage in a subsequent year, and still use that HSA (by preserving the shoebox of health receipts) to reimburse those expenses incurred while HSA-eligible.

HSA eligibility is relevant only for determining the ability to make or receive HSA contributions—not for purposes of taking tax-free medical distributions.

Example 2:

• Same as Example 1, but Phil moves to non-HDHP coverage and loses HSA eligibility as of 2022.

Result 2:

• In 2022 or any future year after losing HSA eligibility, Phil can still continue to incur medical expenses and take tax-free medical distributions from his HSA to pay for such expenses.

• In 2022 or any future year after losing HSA eligibility, Phil can still reimburse himself for the $2,000 in 2021 health expenses incurred (with the records saved in his shoebox).

• The only consequence of Phil’s loss of HSA eligibility is that he cannot make or receive HSA contributions in 2022 or any future year unless he regains HSA eligibility.

The Super Saver Strategy: HSAs as Long-Term Savings Vehicles

Everyone with an HSA needs to ask themselves one important question before using the account to pay for medical expenses: “Do I need to use the HSA funds?”

Insufficient Outside Funds: Use the HSA!

If the answer is “yes,” the choice is clear.  Ultimately, the HSA is designed and intended for use to pay out-of-pocket medical expenses.  Use those HSA funds to cover health costs if it would be an economic hardship to pay from another source.

Sufficient Outside Funds: Save the HSA!

If the answer is “no,” the choice is also clear.  Why drain a triple-tax advantaged HSA only to preserve assets in taxable checking, savings, or brokerage accounts?  In other words, the HSA should become the payer of last resort.  Save your receipts and pay for the expenses outside the HSA if you have the funds available.

It may make you feel uncomfortable to drain your regular accounts to pay for health expenses.  But keep in mind that your HSA funds always remain available to reimburse yourself if you ever need the cash.  The HSA can even double as a tax-free emergency account for some individuals.

For those with more assets, the HSA is really serving as a tax-free forever account.  When paired with the ability to invest your HSA funds in long-term equity strategies, you can harness long-term, tax-free growth in a manner than no other investment or retirement vehicle can match.

Age 65 Bonus: The Dual-Threat Account!

Don’t forget that upon reaching age 65, the 20% additional tax for non-medical distributions is removed.  This essentially converts the non-medical tax treatment of an HSA to that of a traditional 401(k)/IRA.  Upon reaching age 65, non-medical HSA distributions are taxable only as ordinary income.

The HSA bonus is that you can take both medical and non-medical distributions.  Unlike a 401(k) or IRA, your medical HSA distributions will continue to be tax-free.  Furthermore, you can use the HSA to pay for Medicare or other premiums tax-free upon reaching age 65.  (Note: You are no longer eligible to make or receive HSA contributions upon enrollment in any part of Medicare, but you still have the same tax-free distribution options available.)

This makes the HSA a dual threat upon reaching age 65.  You can use the HSA with the same great tax advantage available in traditional retirement savings vehicles, or you can use the HSA for medical expenses to preserve that third leg of the triple-tax advantage.  If you save large amounts in an HSA over your career, most likely you would use it for some combination of both—which is the best of both worlds.

Summary

While the uniquely triple-tax advantaged aspect of HSAs is generally well-known, the HSA provides lesser-known tremendous flexibility in how and when to take distributions.  The shoebox rule allows individuals with an HSA to save it forward by delaying tax-free distributions for medical expenses to future years.

There are no limits to the tax benefits of the shoebox rule.  The longer individuals follow the strategy, the more they can grow the HSA tax-free.

So if you have sufficient assets outside the HSA to cover your health expenses, consider not taking any distributions any HSA distributions until you need the funds.  You can reimburse yourself tax-free from the savings in the HSA at any point in the future if you want or need the funds.

Just don’t lose that shoebox!

Newfront Go All the Way With HSA Guide.

Regulations

IRS Notice 2004-50:

https://www.irs.gov/irb/2004-33_IRB#NOT-2004-50

Q-39. When must a distribution from an HSA be taken to pay or reimburse, on a tax-free basis, qualified medical expenses incurred in the current year?

A-39. An account beneficiary may defer to later taxable years distributions from HSAs to pay or reimburse qualified medical expenses incurred in the current year as long as the expenses were incurred after the HSA was established. Similarly, a distribution from an HSA in the current year can be used to pay or reimburse expenses incurred in any prior year as long as the expenses were incurred after the HSA was established. Thus, there is no time limit on when the distribution must occur. However, to be excludable from the account beneficiary’s gross income, he or she must keep records sufficient to later show that the distributions were exclusively to pay or reimburse qualified medical expenses, that the qualified medical expenses have not been previously paid or reimbursed from another source and that the medical expenses have not been taken as an itemized deduction in any prior taxable year. See Notice 2004-2, Q&A 31 and also Notice 2004-25, for transition relief in calendar year 2004 for reimbursement of medical expenses incurred before opening an HSA.

Example. An eligible individual contributes $1,000 to an HSA in 2004. On December 1, 2004, the individual incurs a $1,500 qualified medical expense and has a balance in his HSA of $1,025. On January 3, 2005, the individual contributes another $1,000 to the HSA, bringing the balance in the HSA to $2,025. In June, 2005, the individual receives a distribution of $1,500 to reimburse him for the $1,500 medical expense incurred in 2004. The individual can show that the $1,500 HSA distribution in 2005 is a reimbursement for a qualified medical expense that has not been previously paid or otherwise reimbursed and has not been taken as an itemized deduction. The distribution is excludable from the account beneficiary’s gross income.

IRS Notice 2004-2:

https://www.irs.gov/irb/2004-02_IRB#NOT-2004-2

Q-28. How are distributions from an HSA taxed after the account beneficiary is no longer an eligible individual?

A-28. If the account beneficiary is no longer an eligible individual (e.g., the individual is over age 65 and entitled to Medicare benefits, or no longer has an HDHP), distributions used exclusively to pay for qualified medical expenses continue to be excludable from the account beneficiary’s gross income.