Why Is My HSA Being Taxed? Distributions, Limits, and Medicare

Your HSA is being taxed because something broke the tax-free rules the account depends on. The most common reasons are spending the money on non-medical items, contributing more than the IRS allows, losing eligibility for a high-deductible health plan, enrolling in Medicare, mishandling a rollover, inheriting the account as a non-spouse, or living in a state that doesn’t recognize the federal HSA tax break. The costliest mistake is a non-qualified withdrawal before age 65, which brings regular income tax plus a 20% penalty on the amount you took out.¹

You Spent the Money on Something Non-Medical

If you used HSA funds for anything other than a qualified medical expense, two taxes stack on top of each other. The full withdrawal gets added to your taxable income for the year. The IRS then adds a 20% penalty on the same amount.¹ Pull $5,000 for a vacation while sitting in the 22% federal bracket and you’re looking at roughly $2,100 in combined tax and penalty.

The 20% penalty goes away at age 65, or earlier if you become disabled or the account owner dies. After 65 the HSA behaves like a traditional IRA for non-medical spending: ordinary income tax applies, but no additional penalty.¹ For anyone younger who isn’t disabled, the penalty is flat and applies no matter the reason.

Distributions are reported on Form 8889, filed with your return. If any portion is non-qualified, that same form is where the 20% additional tax is calculated.²

What Actually Counts as a Qualified Medical Expense

Qualified expenses are defined under IRC Section 213(d) and cover costs for diagnosis, treatment, and prevention of disease.³ In practice that includes doctor visits, hospital bills, prescriptions, dental work, vision care, copays, and deductibles. The expense also has to be incurred after your HSA was established.

Health insurance premiums are where people stumble. Paying your regular monthly health plan premium out of the HSA is almost always a non-qualified distribution. Premiums only qualify in a handful of situations: COBRA continuation coverage, coverage while you’re receiving unemployment benefits, Medicare premiums (Parts A, B, D, and Medicare Advantage), and qualified long-term care insurance.⁴ Cosmetic procedures that aren’t medically necessary don’t qualify either.

The burden of proof sits with you. The IRS doesn’t ask for receipts when you take a distribution, but in an audit you need documentation showing each withdrawal matched an eligible expense. Without that paper trail, the IRS can reclassify the distribution and assess income tax plus the 20% penalty. Keep records as you go.

You Contributed More Than the Annual Limit

For 2026, the limit is $4,400 for self-only HDHP coverage and $8,750 for family coverage.⁵ If you’re 55 or older, add a $1,000 catch-up. Those caps include both your contributions and anything your employer puts in. Any amount above the cap is an excess contribution.

Excess contributions don’t trigger regular income tax on their own, but they carry a 6% excise tax every year the excess stays in the account.⁶ It’s not one-time. Over-contribute by $1,000 and leave it there, you owe $60 this year, another $60 next year, and so on.

The fix is to withdraw the excess plus any earnings it generated before your tax filing deadline, including extensions. Remove it in time and the principal isn’t taxed, though the earnings on that excess are included in your gross income for the year.¹ Miss the deadline and the 6% excise tax gets reported on Form 5329 each year until the excess is cleared out.⁷

Excess contributions are easy to create by accident. Switching jobs mid-year with contributions from both employers does it. Moving between self-only and family coverage does it. And if you weren’t covered by an HDHP for the full year, your contribution limit is prorated by the months you were eligible, which catches people off guard.

You Lost HDHP Eligibility After Using the Last-Month Rule

The last-month rule lets you contribute the full annual amount if you’re HSA-eligible on December 1, as if you’d been eligible all year.² The catch: you have to stay eligible through a 13-month testing period that runs from that December 1 through December 31 of the following year.

Lose eligibility during the testing period, say by switching to a non-HDHP plan in March, and the extra contributions you made under the last-month rule get added back to your gross income. A 10% additional tax applies on that amount.⁴ The only exceptions are death and disability.

You Enrolled in Medicare

This one trips up people working past 65. Once you enroll in Medicare Part A or Part B, you can no longer contribute to an HSA. Your monthly contribution limit drops to zero even if you’re still on an HDHP through work. Contributions made after Medicare coverage begins are excess contributions subject to the 6% annual excise tax.⁶

There’s a quieter version of the same trap. If you delay enrolling in Medicare Part A and later sign up, your Part A coverage gets backdated up to six months. Contributions you made during those backdated months become excess contributions after the fact, even though you weren’t on Medicare at the time. If you plan to enroll after 65, stop HSA contributions at least six months before your enrollment date.

Spending down an existing balance is still fine. You can use HSA funds tax-free on qualified medical expenses after enrolling, and Medicare premiums for Parts A, B, and D count as qualified expenses.⁴ The restriction is on new contributions only.

You Mishandled a Rollover

Two different rollover rules create tax surprises. The first is the one-time IRA-to-HSA transfer. Done correctly, it moves retirement funds into your HSA without income tax or early withdrawal penalties, capped at your annual contribution limit for the year. But you have to stay HSA-eligible for 12 months after the transfer. Lose HDHP coverage during that window and the entire rollover gets added to your taxable income, with a 10% additional tax on top.¹ Note the 10%, not the usual 20%. Death and disability are the only exceptions.

The second is moving money between two HSAs. A direct trustee-to-trustee transfer is safe because you never touch the funds. An indirect rollover is where things break. You have exactly 60 days from receiving the distribution to deposit it into the new HSA. Miss that deadline and the IRS treats the whole amount as a taxable distribution, with the 20% penalty if you’re under 65.¹ Indirect rollovers are also limited to one every 12 months. Direct transfers avoid both constraints.

You Inherited the Account as a Non-Spouse

If you inherited an HSA from someone other than a spouse, the tax hit is significant. The account stops being an HSA on the date of death. The entire fair market value becomes taxable income to the beneficiary in the year the account holder died.⁸ A $50,000 balance can push a non-spouse beneficiary into a higher bracket in a single year.

One offset exists: the taxable amount is reduced by any qualified medical expenses the deceased incurred before death that the beneficiary pays within one year afterward. The 20% penalty does not apply to distributions triggered by the account holder’s death, regardless of the beneficiary’s age. A spouse named as beneficiary gets a very different outcome: the HSA simply becomes theirs with no taxes owed, and it keeps its tax-advantaged status.⁸

Your State Doesn’t Follow the Federal HSA Rules

You can follow every federal rule perfectly and still owe state tax on your HSA. The triple tax advantage of deductible contributions, tax-free growth, and tax-free qualified withdrawals is a federal benefit. A small number of states don’t conform. In those states, HSA contributions aren’t deductible on your state return, and investment earnings inside the account are taxable at the state level each year.

Compliance falls entirely on you. HSA custodians generally don’t issue state-specific forms for the interest, dividends, and capital gains earned inside the account. If you live in a non-conforming state, you have to track those amounts from your account statements and report them yourself. Check your state’s rules before assuming the federal treatment carries over.

1
Office of the Law Revision Counsel. 26 USC 223 – Health Savings Accounts
2
Internal Revenue Service. Instructions for Form 8889 – Health Savings Accounts (HSAs)
3
Office of the Law Revision Counsel. 26 US Code 213 – Medical, Dental, Etc., Expenses
4
Internal Revenue Service. Publication 969 – Health Savings Accounts and Other Tax-Favored Health Plans
5
Internal Revenue Service. Revenue Procedure 2025-19
6
Office of the Law Revision Counsel. 26 USC 4973 – Tax on Excess Contributions to Certain Tax-Favored Accounts and Annuities
7
Internal Revenue Service. Instructions for Form 5329
8
Office of the Law Revision Counsel. 26 US Code 223 – Health Savings Accounts