Moving from HSA Plan to Medicare? Beware the Six-Month Retro Rule!

Did you know that your part of your Medicare coverage may be retroactive? This provisions can create confusion around Health Savings Account contribution limits during your final year of eligibility.

Most Health Savings Account owners know that once they enroll in Medicare, they can no longer fund their account. But most Americans - even those approaching retirement - understand how Medicare works. That's unfortunate because a key provision of Medicare coverage may disqualify them from contributing to a Health Savings Account up to six months prior to what they believe is their effective date of Medicare coverage. Let's explore this issue in more detail.

Eligibility to Fund a Health Savings Account

To open and fund a Health Savings Account, you must meet all eligibility requirements. These requirements fall into three categories:

1. You can't qualify as another taxpayer's dependent (see Section 152 of the Internal Revenue Code). This typically isn't a problem for adults, unless they're disabled.
2. You must be covered on an HSA-qualified plan. This requirement is straightforward, though sometimes people enroll in plans that meet the statutory minimum annual deductible ($1,400 for self-only and $2,800 for family coverage) and believe that they have the right coverage, even though the plan provides certain services below the deductible (such as copays for generic drugs or full coverage for certain chronic conditions) that renders it non-qualified.
3. You can't be enrolled in any disqualifying coverage, such as a spouse's medical plan, a general Health FSA, or, directly related to this topic, any Part of Medicare.

Medicare as Disqualifying Coverage

Section 223 of the Internal Revenue Code, which governs Health Savings Accounts, specifically lists Medicare as disqualifying coverage. Why?

Medicare doesn't offer an HSA-qualified option. Part A, which covers inpatient care, plus hospice and home health services, has a deductible of $1,556 per inpatient stay. That figure is well above the $1,400 statutory minimum deductible required for a plan to be HSA-eligible.

But Part B, which covers outpatient services, has a $233 deductible, after which patients pay 20% of the allowable charges. Thus, a patient who doesn't receive inpatient care pays a deductible of only $233 before her insurance begins to reimburse providers on her behalf.

Enrolling in Medicare

Most Americans are eligible to enroll in Medicare coverage that starts on the first day of the month that they turn age 65 (or the first day of the month before, if their birthday is on the first day of the month). But there's a difference between being eligible to enroll, being automatically enrolled, and having the option to defer enrollment.

Automatic enrollment. Anyone age 65 or older who receives Social Security or federal Railroad Retirement benefits is automatically enrolled in Part A as of the month of their 65th birthday. Thus, the more than half of all Americans who begin to collect Social Security benefits before age 65 are auto-enrolled as of their 65th birthday. They must cease to fund a Health Savings Account as of that month. The only way to continue to fund a Health Savings Account is to disenroll retroactively from Social Security and repay all benefits received. For most Social Security recipients, that's too high a financial barrier to hurdle in exchange for additional years of tax savings with Health Savings Account contributions.

Voluntary enrollment. If you're not collecting Social Security benefits, you're not automatically enrolled in Medicare at any age. You must actively enroll. Not everyone understands this key point. Some seniors report that they were confused by a mailing from Medicare shortly before their 65th birthday, from which they inferred that they were required to enroll in Medicare or that they would face lifetime penalties if they didn't enroll promptly. But that inference isn't correct. Absent receiving federal retirement benefits, no one must enroll in any Part of Medicare.

If you remain active at work and your company has 20 or more employees, your employer-sponsored plan is your primary coverage. Part A, while it has a zero premium for most seniors, provides little additional coverage above what a typical company HSA-qualified plan reimburses. Part B, with a monthly premium of $170.10 or higher, may offer more benefits, but they must be weighed against cost. Ditto for Part D, which charges a premium (which varies by private insurers that offer this coverage).

The Medicare Retro Rule

If you enroll in Medicare after age 65, your coverage will take effect retroactively, up to six months before the date on which you enroll. This is true whether you want or need retroactive coverage, and regardless of how retroactive coverage might affect your financial situation. Here's how it works:

Enroll at age 65. No retroactive coverage.

Enroll between age 65 and age 65 and five months. Retroactive coverage back to the first day of the month of your 65th birthday.

Enroll on or after age 65 and six months. Retroactive coverage of six months.

Example: You continue to work and fund your Health Savings Account until you reach age 66 years and six months in August 2022, when you qualify for your full Social Security benefit. You're automatically enrolled in Part A and choose Part B coverage as well. Your Part A coverage is retroactive to Feb. 1, 2022. You lose your eligibility to fund a Health Savings Account Feb. 1, 2022.

The Part A six-month retroactive enrollment isn't written into any legislation. It's just a standard that Medicare has applied since the 1990s. It's generally considered a harmless feature - it may reimburse a portion of prior inpatient care that commercial coverage didn't pay, and enrollees don't pay a premium for this coverage. But with the introduction of Health Savings Accounts in 2004, this plan feature suddenly did cost people something - the opportunity to reduce income and save for retirement expenses during their final months of employment.

You've Already Funded Your Account. Now What?

In the example above, you deposit $193.75 per semi-monthly pay period into your Health Savings Account (that's your maximum contribution of $4,640 divided by 24 pay periods). By the time you retire July 31, you've deposited $2,712.50 ($193.75 times 14 pay periods). But with your retroactive Medicare coverage, you were eligible to fund your account only for January ($387.50, or $193.75 times two pay periods). You've overfunded your account by $2,325. What to do?

There's a simple fix. You withdraw $2,325, plus any earnings associated with that amount, and include it in your 2022 taxable income. With this one step, you correct the excess contribution and bring yourself back into compliance with federal tax law.

What if you've spent funds and no longer have a balance that exceeds $2,325? In this case, you can't withdraw what's not there, and you're not eligible to contribute more. Any funds that you weren't eligible to contribute and you then spent are considered distributions for non-qualified expenses (even if you reimbursed qualified medical, dental, and vision expenses, or Medicare premiums). You must include that amount in your taxable income. Unlike people under age 65, you don't have to pay an additional 20% tax as a penalty.

The Bottom Line

The best way to address the Part A retroactive-coverage rule is to know about it prior to enrolling in Medicare and to stop funding your account six months before your effective date of enrollment. This option is ideal for those who have planned their retirement carefully, understand Medicare rules, and see their retirement unfold as planned.

Many others don't have the luxury of knowledge and a plan that see their retirement plans come to fruition as, well, planned. In these cases, there is a way to correct overfunding during the last year of retirement.

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