Distributions from an HSA are permitted at any time, and if used exclusively to pay for qualified medical expenses of the account beneficiary, his or her spouse, or dependents, are excludable from gross income. Distributed amounts not used to pay for qualified medical expenses are includible in the account beneficiary’s gross income and are subject to a 20% penalty tax. However, the penalty does not apply if the distribution is made on account of the beneficiary’s:

Amounts withdrawn from an HSA to pay for the account’s administration and maintenance fees are not treated as taxable distributions. (If these fees are paid directly by the account beneficiary or employer, they will not be considered contributions to the HSA, and therefore, won’t count toward the annual maximum contribution limit.)

Where an account beneficiary receives an HSA distribution as the result of a mistake of fact due to reasonable cause (e.g., the account beneficiary reasonably, but mistakenly, believed that an expense was a qualified medical expense and was reimbursed for that expense from the HAS), can the account beneficiary then repay the mistaken distribution to the HSA and avoid a taxable distribution?

If there is clear and convincing evidence that amounts were distributed from an HSA because of a mistake of fact due to reasonable cause, the account beneficiary may repay the mistaken distribution no later than April 15 following the first year the account beneficiary knew or should have known the distribution was a mistake. Under these circumstances, the distribution is not included in gross income under section 223(f)(2), or subject to the 10% additional tax under section 223(f)(4), and the repayment is not subject to the excise tax on excess contributions under section 4973(a)(5).

However, it is optional for the trustee or custodian to accept a return of mistaken distributions. If the HSA trust or custodial agreement allows the return of mistaken distributions, the trustee or custodian may rely on the account beneficiary's representation that the distribution was, in fact, a mistake.

Qualified Medical Expenses are unreimbursed expenses paid by the account beneficiary, his or her spouse, or dependents for medical care as defined in Code § 213(d), i.e., generally the same definition used for itemized deduction medical expenses. However, amounts paid for over-the-counter drugs are allowable as an HSA expense for years after 2019 (the CARES Act removed the requirement that the drugs be prescription drugs). Insulin is also an allowable expense. Note that this change does not have an expiration date and does not apply to Schedule A expenses for drugs, which still are allowed only for prescribed drugs and insulin. The CARES Act also added feminine menstrual products as expenses eligible for tax-free reimbursement from an HSA, effective for expenses incurred for years after December 31, 2019. IRS Announcement 2021-7 added COVID-19 personal protective equipment to the list of reimbursable expenses.

The qualified medical expenses must be incurred only after the HSA has been established. Medical expenses paid or reimbursed by HSA distributions cannot also be claimed as a medical expense for itemized deduction purposes.

Generally, health insurance premiums are not qualified medical expenses for HSA purposes, except for the following:

HSA distributions to pay long-term care insurance premiums are excludable only up to the annual age-based limit that applies for deducting long-term care premiums as medical expenses.

The tax-free treatment of distributions from an HSA continues even if the account beneficiary is no longer an eligible individual (because of enrolling in Medicare or no longer having an HDHP), as long as the distributions are used exclusively to pay qualified medical expenses.

HSA trustees or custodians and employers who contribute to an employee’s HSA are not required to determine whether HSA distributions are used for qualified medical expenses. Individuals who establish HSAs make that determination and should maintain records to substantiate that the distributions were used exclusively for qualified medical expenses.

There is no time limit on when a distribution from an HSA must be taken to pay or reimburse qualified medical expenses, but the HSA trustee may put reasonable restrictions on the frequency and minimum amount of distributions. To be excludable from the account beneficiary’s gross income, he or she must keep records sufficient to later show that the distributions were exclusively to pay or reimburse qualified medical expenses, that the expenses weren’t previously paid or reimbursed from another source, and that the medical expenses have not been taken as an itemized deduction in any prior tax year.