There are some risks involved with this strategy that need to be discussed, but are rarely mentioned in discussions about this strategy.
IRS Publication 969 sets forth the recordkeeping requirements when making distributions of qualified medical expenses:
Recordkeeping. You must keep records sufficient to show that:
- The distributions were exclusively to pay or reimburse qualified medical expenses,
- The qualified medical expenses hadn’t been previously paid or reimbursed from another source, and
- The medical expenses hadn’t been taken as an itemized deduction in any year.
The second requirement may prove difficult for someone who intends to defer HSA reimbursements over a long period. You are essentially required to prove a negative: prove that you did not receive a reimbursement from another source (such as another health insurance plan or another HSA/FSA/HRA). This, strictly speaking, is an impossible burden, but as a practical matter, it won’t present any problem for someone who is taking HSA reimbursements as expenses are incurred.
If you incur an expense this year, take an HSA reimbursement for it this year, and receive an IRS inquiry about it in 2019, the IRS will almost certainly accept (for the second requirement) the EOB and a statement from you that you did not receive any reimbursement from another source. But, if you incur an expense this year, take an HSA reimbursement for it in 2040, and receive an IRS inquiry about it, you may have a more difficult time. The statement you make in 2040 that you did not have secondary health coverage in 2017 and did not receive a reimbursement of the expense from another source between 2017 and 2040 is inherently less credible than the same statement made in 2019. It is uncertain precisely what the IRS and courts will see as sufficient proof when a long period has passed between the expense being incurred and the reimbursement.
Additionally, there is a risk that the IRS, or even individual auditors within the IRS, could come to see this strategy as abusive (even though it appears to be legal under the current law). That could cause them to be more stringent with the type of proof they will accept to satisfy this requirement for deferred HSA reimbursements.
Uncertain treatment upon death of HSA holder
If you die while deferring expenses for later HSA reimbursement, the beneficiary of your HSA may not have an opportunity to take tax-free reimbursements of those expenses. IRS Publication 969 explains what happens to HSAs upon the death of the holder:
You should choose a beneficiary when you set up your HSA. What happens to that HSA when you die depends on whom you designate as the beneficiary.
Spouse is the designated beneficiary. If your spouse is the designated beneficiary of your HSA, it will be treated as your spouse’s HSA after your death.
Spouse isn’t the designated beneficiary. If your spouse isn’t the designated beneficiary of your HSA:
- The account stops being an HSA, and
- The fair market value of the HSA becomes taxable to the beneficiary in the year in which you die.
- If your estate is the beneficiary, the value is included on your final income tax return.
The amount taxable to a beneficiary other than the estate is reduced by any qualified medical expenses for the decedent that are paid by the beneficiary within 1 year after the date of death.
If your spouse is not the designated beneficiary, the entire HSA balance is taxable to the beneficiary upon your death. There is no provision for the beneficiary to take tax-free reimbursements of expenses you paid before death and deferred. The 1-year rule appears to only apply to expenses actually paid by the beneficiary after your death.
If your spouse is the designated beneficiary, there is ambiguity as to whether your spouse would be able to take tax-free reimbursements for your deferred expenses. The account retains its HSA status, which is probably helpful.
Possible legislative changes in the future
Congress could act at some future time to limit the time period for taking tax-free distributions of medical expenses, especially if this strategy becomes more popular. Any such change will doubtlessly be discussed on personal finance forums, blogs, etc. well ahead of time, so if you’re keeping up with those, you should be able to take your deferred reimbursements prior to the effective date of any such change. However, if you stop keeping up-to-date on relevant developments (or are unable to), there is a risk that you could unknowingly lose the tax benefit of some or all of the reimbursements you were deferring.
This is only intended as a general cautionary statement; I am not aware of any Congressional proposal or discussion to actually change this (though that doesn’t mean it hasn’t happened).
If you are deferring HSA reimbursements and have unused IRA space at some point, there is no reason not to take HSA reimbursements up to the amount of your unused IRA space and contribute the funds to a Roth IRA. The earnings will be tax-free upon retirement, the contribution can be withdrawn without penalty, and you avoid the long-term recordkeeping burden for those medical expenses. Reimburse the oldest medical expenses first.