Kid's No Longer Your Tax Dependent? HSA Reimbursement Rules Change!

It's inevitable. At least you hope it is. You provide for a child's support for 18 or 22 or 24 years as the child grows physically, intellectually, emotionally, and financially. When the day arrives that you're no longer providing half or more of the child's support, some new Health Savings Account rules apply.

It's one of the joys of parenting - seeing an adult child drop from your payroll. No more college payments. No heavy subsidies for housing during an internship or first job. No allowance to help the child make ends meet. But be sure you understand how your child's change in tax status - from your tax dependent to independence - affects your (and your child's potential) Health Savings Account.

Defining a Tax Dependent

Tax status is defined under Section 152 of the Internal Revenue Code. Here's a quick summary from IRS Publication 502 (version to file 2021 tac returns) that covers must family situations:

Qualifying Child

A qualifying child is a child who:

1. Is your son, daughter, stepchild, foster child, brother, sister, stepbrother, stepsister, half brother, half sister, or a descendant of any of them (for example, your grandchild, niece, or nephew);
2. Was:
3. Under age 19 at the end of 2021 and younger than you (or your spouse if filing jointly),
4. Under age 24 at the end of 2021, a full-time student, and younger than you (or your spouse if filing jointly), or
5. Any age and permanently and totally disabled;
6. Lived with you for more than half of 2021;
7. Didn't provide over half of his or her own support for 2021; and
8. Didn't file a joint return, other than to claim a refund.

In other words, generally, if your child lives with you and you pay more than half her support, she qualifies as your tax dependent.

Tax Dependents, Health Savings Accounts, and Opening an Account

When a child is your tax dependent, two things happen. First, the child can't open or fund a Health Savings Account. Second, you can reimburse your child's qualified expenses tax-free from your account. Let's look at each.

A tax dependent can't open a Health Savings Account and make or receive contributions. This is different from bank accounts and Individual Retirement Arrangements, or IRAs (which require the child to earn income to deposit). In simple terms, when your child starts babysitting or working at a day care or summer camp, you can help her open her own IRA. If she has documented income (pay slips, not simply cash payments under the table to babysit), she can fund an IRA. You can contribute as well, so long as total contributions don't exceed her allowable amount.

Not so with Health Savings Accounts. You may want to give your child a leg up on funding qualified health-related expenses in retirement. Good for you. These financial lessons give children a huge advantage over those whose parents are less financially savvy. But your child can't open a Health Savings Account. So, your best bet is probably to help the child open and contribute to a Roth IRA, whose contributions are taxable (unlike Health Savings Account contributions, but whose distributions (with few restrictions) are always tax-free. Since your child will have little or no tax liability at a low level of income, this substitution benefits even the child who's shut out of Health Savings Accounts.

Tax Dependents, Health Savings Accounts, and Opening and Qualified Distributions

If your child no longer qualifies as your tax dependent, you can't reimburse any of her qualified expenses tax-free. That's true even if she remains covered on your medical plan until age 26 (as required in most cases under federal law).

Example: My son, who turned 25 yesterday [interestingly, on the day that, according to his biography, George Jetson of The Jetsons was born], is covered on my family medical plan. But I can't reimburse tax-free any deductible or coinsurance expenses that he incurs from my Health Savings Account. If I withdraw funds to pay his expenses, I must include the distribution as taxable income tax on my federal tax return and pay an additional 20% tax as a penalty.

What's a Child to Do?

It's important to understand that eligibility to open and fund a Health Savings Account is determined family-member-by-family member. If the child who's no longer your (or anyone's) tax dependent is enrolled on HSA-qualified coverage, regardless of his tax status or who the plan subscriber is, and has no disqualifying coverage, she may be able to open and fund a Health Savings Account.

Example: My aforementioned son is covered on my family plan, isn't my tax dependent, doesn't have access to reimbursement through a general Health FSA or Health Reimbursement, isn't a veteran with disqualifying coverage, isn't a Native American who can receive care through the Indian Health Services, and doesn't participate in a direct-primary care arrangement. Thus, he's qualified to open and fund his own Health Savings Account.

Incidentally, the child doesn't need earned income to contribute, nor are contributions limited to the child. A parent or anyone else can contribute.

What Are the Child's Contribution Limits?

That's a great question. One that we'll take up next week! You'll be pleasantly surprised.

The Bottom Line

Health Savings Account compliance rules giveth and taketh away when a child no longer qualifies as your tax dependent. You lose the opportunity to reimburse your child's expenses tax-free from your account. But your child can begin to fund her own account once she's no longer your tax dependent. Doing so promptly will give her a huge leg up on planning for her retirement medical expenses four decades or more in the future.

HSA Wednesday Wisdom

Don't forget to read our weekly HSA Wednesday Wisdom article as well. It's a complementary column that discusses Health Savings Account issues beyond compliance rules. During the first four weeks of August, we'll discuss four distinct tax advantages of Health Savings Accounts that aren't captured in the popular triple-tax-savings description of these accounts. You can FOLLOW your Health Savings Academy on LinkedIn to have this content delivered weekly to your news feed.

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