Rolling Over an HSA

I learned that my provider HSA can be rolled over to a more managed broker (e.g. Fidelity Investments). Unusual state tax implications came to my awareness and begged questions. Additional questions on HSA investments and use arose. The following is my understanding (disclaimer: educational and informational only).

One can take a tax-free HSA distribution many years later to reimburse myself for a qualified medical expense that occurred after my HSA was established, provided I retained adequate documentation and the expense wasn’t previously reimbursed or deducted.

Don’t liquidate your existing HSA investments until you know exactly how your current HSA custodian handles the transfer.

Ask them:

“Can you perform a trustee-to-trustee HSA transfer to Fidelity while transferring my investments in kind, without liquidating them?”

Also ask new Custodian (e.g. Fidelity) whether the particular investments in your existing HSA are eligible for an in-kind HSA transfer.

Paying medical expenses from ordinary cash today, preserving the receipts, and allowing the HSA to remain invested is legitimate under federal law.

The important qualification is that the expense must have been incurred after the HSA was established, and you must be able to document that:

  • it was a qualified medical expense;

  • you weren’t reimbursed from insurance or another source; and

  • you didn’t claim the expense as an itemized medical deduction.

The IRS explicitly states that there is no time limit on when the HSA distribution can occur.

Federal:

HSA distribution → qualified medical expense → tax-free

California:

California does not impose California income tax on the entire HSA distribution simply because it came out of an HSA.

Instead, California has already been taxing the investment income generated inside the HSA along the way.

The concern is primarily the investment activity inside the HSA, particularly if investments must be sold during the rollover.

If the investments are liquidated during the rollover, California recognizes the $5,000 gain and taxes it. Fidelity’s hypothetical California taxpayer pays $400 at an assumed 8% marginal rate.

Selling appreciated investments can create a California capital gain, because California doesn’t give HSAs the same tax shelter that federal law does.

If the assets can be transferred in kind, there generally isn’t a federal taxable event, and you avoid creating a capital gain merely because you changed HSA custodians.

Fidelity itself says direct transfers can move cash and investments to the new provider.

This is generally the cleanest approach.

If custodian A liquidates all HSA assets prior to rolling over to custodian B: the exact tax would depend on your California taxable income and the nature of the gain.

Funds invested in the HSA and allowed to grow 10–20+ years, can eventually reimburse yourself the original investment as federal tax-free, while the money had potentially compounded inside the HSA.

After 65, HSA money can also be used tax-free for qualified medical expenses, including certain Medicare premiums. The IRS specifically allows Medicare and certain other health coverage premiums after age 65, although Medigap premiums aren’t eligible.

HSA Basics

  • The IRS definition for HSA purposes generally incorporates medical care under IRC §213(d). Publication 969 says qualified medical expenses are amounts paid for medical care for you, your spouse or dependents, to the extent they aren’t compensated by insurance or otherwise.

  • The HSA custodian generally does not require you to submit medical receipts when you take a distribution. You are responsible for determining whether the distribution is qualified and retaining documentation in case the IRS later asks you to substantiate it.

  • When you file your federal tax return:
    You report the HSA distributions on Form 8889, but you generally don’t attach your receipts.

  • If the IRS audits you: This is when your documentation becomes important. You may be asked to demonstrate that the distributions were for qualified medical expenses.

  • Think of the HSA as operating largely on an honor-and-recordkeeping system, rather than a reimbursement-approval system.

  • If considering allowing the HSA to compound for many years—I would keep more than the bare minimum.

Documentation Recommended?

  • Itemized provider receipt/bill Yes

  • Date of service Yes

  • Patient’s name Yes

  • Provider name Yes

  • Description of service Yes

  • Amount you actually paid Yes

  • Insurance EOB Strongly recommended

  • Evidence insurance didn’t reimburse entire amount Recommended

What was the expense, when did I incur it, how much did I pay, and why was it a qualified medical expense?

A simple scan/PDF/photo of an itemized receipt is generally an excellent record. Fidelity itself recommends keeping receipts, claims documentation and explanations of benefits.

Suggests creating an HSA receipt archive

Maintain a spreadsheet with:

Date | Provider | Patient | Service | Amount | Insurance paid | Out-of-pocket | HSA reimbursement taken? | Receipt/EOB filename

And save the actual PDFs/JPEGs in a dedicated folder.

That would make an eventual IRS audit substantially easier.

Qualifying Medical Expenses?

  • The IRS specifically says therapy can qualify when it is treatment for a disease. For example, therapy treating a diagnosed mental illness can qualify, whereas ordinary marital counseling does not.

  • Psychotherapy for treatment of a diagnosed condition—generally qualifying

  • Therapy for a medical condition/injury—generally qualifying

  • Marital counseling without treatment of a disease—generally not qualifying

  • General life coaching/wellness counseling—generally not qualifying

  • The IRS specifically lists acupuncture as an includible medical expense.

  • The IRS specifically says that fees paid to a chiropractor for medical care can be included as medical expenses.

Michael Wei