A Health Savings Account (HSA) is one of the most flexible, tax-advantaged savings options available. If you've ever wondered how an HSA works, especially when dependents are involved, you're not alone. HSAs let employees save pre-tax dollars for eligible healthcare costs, but some employees run into trouble when it comes to dependent rules.
If you offer a qualified High-Deductible Health Plan (HDHP), your employees may be able to open an HSA to help save for eligible medical expenses with pre-tax dollars.
These funds can also be used for your employees' tax dependents, but there are some eligibility rules to consider.
How Does an HSA Work?
An HSA can be a versatile financial tool designed to help people save and pay for eligible medical expenses. Whether they're planning for current healthcare costs or looking ahead to future needs. HSAs offer several unique benefits that can make them an attractive option for managing medical expenses more efficiently. HSA funds:
- Can be used tax-free for eligible medical expenses (like deductibles and copayments) for the account holder, their spouse, or tax dependents
- Roll over year to year with no "use or lose" rule
- Can even grow tax-free with interest or investments over time
- Are the account holders to keep even if they switch jobs or retire
What is an HSA Contribution?
An HSA contribution is the money you or your employee deposit into an HSA each year. Contributions may be made through payroll deductions, direct deposits, or lump-sum payments. The IRS sets annual limits to prevent overfunding and going beyond those HSA limits can lead to penalties.
2025 HSA Contribution Limits
| Coverage Type | Max HSA Contribution Limit | Catch-Up Contribution (Age 55+) |
| Individual | $4,300 | +$1,000 |
| Family | $8,550 | +$1,000 (per eligible person) |
2026 HSA Contribution Limits
| Coverage Type | Max HSA Contribution Limit | Catch-Up Contribution (Age 55+) |
| Individual | $4,400 | +$1,000 |
| Family | $8,750 | +$1,000 (per eligible person) |
HSA Withdrawal Rules
Like contributions, withdrawals also follow strict rules. HSA funds may be withdrawn tax-free when used for eligible medical expenses for the employee, their spouse, or tax dependents. If an account holder withdraws HSA funds for non-qualified expenses before age 65, the amount is subject to income tax and a 20% penalty. After age 65, non-medical withdrawals are still taxable but no longer penalized.
Adult Child Dependents and HSAs
There is an important difference between the Affordable Care Act (ACA) rules and HSA rules for dependents. The ACA requires major medical plans to cover dependents until age 26, but it doesn't require these dependents to be tax dependents.
To use HSA funds for dependent expenses, the dependent must qualify as a dependent on the HSA account holder's tax return. Because of this, a scenario could exist where an employee's adult dependents are covered on the medical plan, but the employee's HSA cannot be used to cover medical expenses for those dependents.
How the Rule Applies to Adult Children
Let's say an employee's 24-year-old son is employed, files his own tax returns, and is not eligible to be claimed as a tax dependent on his parents' tax return. He may be enrolled in his parents' qualified HDHP until he reaches age 26, but their HSA funds cannot be used to help pay his out-of-pocket medical expenses.
Because the employee's HSA funds can't be used for this dependent, the adult child may wish to establish his own HSA for expenses. Here's how this works: the adult child, as an independent taxpayer covered under a family-qualified HDHP, can open an HSA and contribute up to the family contribution limit ($8,750 for 2026).
The parent may also contribute up to the same family contribution limit to their own HSA. However, it's important to note that the total contributions across all HSAs within the family plan cannot exceed the family limit of $8,750, regardless of the number of accounts.
This allows the employee's HSA funds to be used for the employee, spouse, and other qualified dependents, while the adult child has his own HSA funds to use for eligible medical expenses.
Keep in mind that the primary account holder cannot use pre-tax salary reductions to contribute to the adult child's HSA. Also, the adult child's HSA can only be used for the adult child and their qualifying tax dependents' eligible out-of-pocket medical expenses.
Child Dependents of Divorced Parents
For purposes of eligible medical expenses, under some circumstances, a child of divorced or separated parents can be treated as a dependent of both parents. In this case, each parent can use their HSAs to pay for eligible medical expenses for the child, even if the other parent claims the child as a dependent.
The parent can use HSA funds to pay eligible medical expenses for the child if:
- The child is in the custody of one or both parents for more than half of the year
- The child receives more than half of their support during the year from their parents
- The child's parents:
- Are legally divorced or separated
- Are separated under a written agreement
- Always lived apart during the last six months of the year
This does not apply if the child’s exemption is being claimed under a multiple support agreement. To find out more about covering children and children of divorced or separated parents, please see Internal Revenue Service (IRS) Publication 969 or consult your tax advisor.
Common HSA Mistakes Beyond Dependents
Even though HSAs are powerful savings tools, employees often make avoidable mistakes that can lead to tax penalties or missed savings opportunities. Some of the most frequent errors include:
- Over-contributing to the account: Each year the IRS sets limits on how much can be added to an HSA. Putting in more than the annual limit can trigger a 6% excise tax unless the excess is corrected before the tax deadline.
- Paying for ineligible expenses: Before age 65, HSA funds can only be used for IRS-qualified medical expenses (FSA and HSA Eligibility List). Using the money for non-qualified costs—like cosmetic procedures, gym memberships, or general household items—means the amount becomes taxable income and may face a 20% penalty.
- Using funds for non-dependents: HSA distributions are only tax-free when used by the account holder, their spouse, or qualified tax dependents, not when paying medical bills for a fiancé, roommate, or adult child who can't be claimed as a dependent.
- Confusing HSAs with FSAs: Unlike a Flexible Spending Account (FSA), HSA balances roll over year to year and grow tax-free. Some employees mistakenly think they must "use or lose," which can lead to unnecessary spending.
- Not naming a beneficiary: If an HSA owner passes away without naming a beneficiary, the account balance becomes taxable income to the estate. Naming a spouse or dependent as beneficiary can help preserve the tax-advantaged status of the funds.
- Failing to save expense documentation: The IRS can request proof that HSA distributions were used for eligible medical expenses. Without documentation, employees may struggle to verify their spending and could face taxes and penalties during an audit.
How to Help Employees Follow HSA Rules
The best way to help your employees avoid missteps with their HSA is to educate your employees on these dependent child rules, as well as guiding employees to ask the right questions during enrollment. Ask your employees questions to help identify dependents who may be adults or who a former spouse may be covering. This can help guide employees to using the HSA correctly.
American Fidelity helps employees understand their options by offering one-on-one benefit reviews during enrollment. During these reviews, our account managers can discuss some of your other benefit offerings—including medical, dental, and vision plans. This also creates a chance to address eligibility questions related not only to the HSA but other benefits which may reveal a need for the employe to conduct a Dependent Verification Review.
Clarity Matters with HSAs
HSAs are designed to help give employees a variety of tax advantages and long-term savings options, but those benefits only hold up when the rules are understood and applied correctly. By looking closely at dependent eligibility and the most common pitfalls, it can become clearer that a little knowledge may go a long way in keeping these accounts working as intended.
To learn more about how American Fidelity can help, visit our HSA Support page or contact us today.
Frequently Asked Questions
What happens if an HSA is used incorrectly?
Using an HSA for non-qualified medical expenses may result in financial penalties. If a person is under age 65, these withdrawals are subject to both income tax and an additional 20% penalty tax. Non-qualified distributions must also be submitted on their tax return.
What are the rules for mistaken distributions from an HSA?
If a person made a mistaken distribution from their HSA due to a "reasonable cause," they should consult their tax advisor to find out if they may be able to repay the amount to the account. The person must return the funds no later than the tax filing deadline for the year following the mistake (typically April 15). If the repayment is made correctly, the distribution is not included in their gross income and is not subject to the 20% penalty.
How can HSA penalties be avoided?
To avoid an HSA penalty, employees need to ensure that all withdrawals are used for qualified medical expenses. If an employee accidentally makes an excess contribution, they should consult their tax advisor to find out if they can avoid a penalty by withdrawing the excess funds before the tax filing deadline. Employees nearing retirement should also seek expert advice, as it may be necessary to stop contributing to their HSA at least six months before enrolling in Medicare to avoid penalties for excess contributions.
What is a prohibited distribution from an HSA?
Employees should also work with their advisor to make sure they do not use their HSA in a way that violates the law. In general terms, a prohibited distribution from an HSA is any transaction that constitutes a prohibited transaction under IRS rules, such as using the account as security for a loan or engaging in a loan between the HSA and the account owner. If a prohibited transaction occurs, the HSA is disqualified retroactively to the first day of that year. The entire fair market value of the account is then treated as a taxable distribution and subject to a 20% penalty.
Can HSA contributions be changed at any time?
Yes, employees can generally change their HSA contribution amount at any time during the year. If HSA contributions are being made through a Section 125 plan, employers will generally allow changes at least monthly. To change a pre-tax payroll deduction, employees will need to contact their employer.
What's the difference between a Healthcare FSA and an HSA?
An HSA is a portable, individual-owned savings account that rolls over each year and can be invested. An employee can only open an HSA if they're enrolled in an HSA-qualified HDHP. In contrast, a Healthcare FSA is a reimbursement account with a "use or lose" rule, meaning funds typically must be spent by the end of the plan year. There is not a requirement for a person to be enrolled in a certain major medical plan (or a plan at all) in order to participate in a Healthcare FSA.
This blog is up to date as of September 2022 and has not been updated for changes in the law, administration or current events. American Fidelity does not provide financial, legal, or tax advice. Consult an attorney or a tax professional regarding your specific situation.
HSA investments are connected to the stock market and are subject to rise or fall.
HSA contributions are not subject to federal and most states' income tax. State income tax may apply in California and New Jersey. Please consult a tax advisor for your state's specific rules.
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