Tax Treatment of Health Savings Accounts (HSAs) in California

 

Health Savings Accounts (HSAs) allow individuals to save money on a tax favored basis to pay for medical expenses. A person can open a California HSA only after enrolling in a qualified high deductible medical insurance plan. Anthem Blue Cross of California, Blue Shield of California, Health Net of California, Nationwide Health Plans and Pacificare of California all offer HSA compatible individual and family health insurance plans and small group health insurance.

Employers and individuals and families are increasingly using HSA compatible high deductible health insurance plans as an effective strategy to lower the cost of medical insurance in California.

Modeled after individual retirement accounts (IRAs), HSA are federally tax deductible trusts or custodial accounts used to pay for qualified medical expenses. Earnings in the accounts are never taxed if used for qualified medical expenses.

Current California law (as of October 2005) does not conform to the federal HSA provisions. California tax returns start with federal adjusted gross income (AGI) and require adjustments for differences between federal and California law. According to an excellent description of this issue (California Tax Deductibility of HSA Contributions) current California law requires the following adjustments:

  1. A taxpayer taking an HSA deduction on his federal return must increase AGI by the amount of the federal deduction on his California tax return;
  2. Interest earned on the account must be added to AGI on the California tax return; and,
  3. Any contribution to an HSA made by an employer on behalf of an employee is not excluded from income and must be added to the AGI of the employee on the employee’s California return.

Further California law does not allow tax-free rollovers from a Medical Savings Account (MSA) to an HSA. As such a California tax payer who rolls over an MSA distribution into an HSA must add the amount to AGI on the California tax return.

California Senate Bill 173, introduced by state Senator Maldonado, would generally make the California tax treatment of Health Savings Accounts similar to IRAs. Giving HSAs tax favored status in California would help assist small employers and families to lower the cost of their health insurance.