The HSA “testing period”: The Sophie’s Choice of health care costs

Ouija boardPhoto courtesy of Ann Larie Valentine

Last time, I talked about the maximum contribution you can make to a Health Savings Account (HSA) each year. Contribute any more, and you pay a steep penalty.

We don’t want to do that, but we do want to contribute the maximum we can.

After all, this is pre-tax money, so it goes a lot farther than after-tax money. And since my new insurance plan is so, ahem, underwhelming, every little bit counts.

Normally, your maximum contribution is prorated based on the number of full months you had coverage. But if you gain access to an HSA-eligible plan mid-way through the year and keep it to the end of the year, you can actually contribute as if you had the plan for the full year.

It’s called the “testing period”, and it’s potentially a difference of thousands of dollars!

However, there is, as you might imagine, a catch. In order to not get penalized, you have to, effectively, predict the future. No big deal.

So get out your Ouija boards, it’s time to figure out the “testing period”!

The testing period explained, kind of

Directly from the IRS, here is the definition of the testing period:

If contributions were made to your HSA based on you being an eligible individual for the entire year under the last-month rule [meaning you had coverage in December], you must remain an eligible individual during the testing period…[T]he testing period begins with the last month of your tax year and ends on the last day of the 12th month following that month (for example, December 1, 2016, through December 31, 2017).

If you fail to remain an eligible individual during the testing period, for reasons other than death or becoming disabled, you will have to include in income the total contributions made to your HSA that wouldn’t have been made except for the last-month rule. You include this amount in your income in the year in which you fail to be an eligible individual. This amount is also subject to a 10% additional tax.

This translates as:

You can contribute the full-year amount, but you have to keep HSA-eligible coverage for the entire following calendar year. Failure to do this, and you have to pay a huge penalty on the excess contributions.

My actual situation

I’m going to give you my actual situation as an example, so as to make this more accessible and less esoteric.

I gained coverage on October 2 of this year. This means that I only have two months of eligible coverage (since partial months don’t count; ugh) and can contribute $566 this year.

Or, since I have coverage all through December, I can actually contribute $3,400, if—and only if—I have coverage all the way through December of next year.

So the question is: Do I contribute the prorated amount, foregoing the benefits from the extra contribution, or do I contribute the full-year amount, and risk possibly having to pay a penalty on the excess contributions?

There are two immediate problems with this determination:

  • I don’t know if I’ll remain in this job for another 13 months. I certainly hope and expect to, but I can’t guarantee it.
  • My open enrollment is in November, so this means that I’d necessarily be signing up for this plan for another year in order to pass the testing period. That’s a long time to stick with a potentially bad plan, and I won’t know until I’ve already made the decision.

The only way to solve this is to figure out the risks on both sides, and try to determine the likelihood of each outcome.

Scenarios

Let’s say that I were to contribute the full year amount. And then let’s say that I lose coverage and “fail” the testing period.

That would mean that I would have an excess contribution of $2,834 ($3,400 – $566). I would then need to pay income tax on that amount, plus pay a 10% penalty. That’s around $1,000 in taxes and penalties.

Ouch.

But this implies that I have this high deductible, low-paying plan for two years instead of one.

What if this plan costs more money than the benefits I receive? An extra year of this plan could be quite expensive.

And that’s the problem: even if I keep my plan and am not subject to the penalties, I have no idea how to even know how potentially more (or less?) expensive my plan would be when compared to another option.

You see how impossible this is? It’s all a big guess.

Okay, perhaps it’s a bit hyperbolic to reference “Sophie’s Choice“, a story of a mother who needed to decide which of her children would die. But it still feels like an impossible decision, with lots of money riding on it.

Pros and cons

Here’s what I’ve been able to figure out about paying the full-year amount:

  • Pros:
    • Roughly $2,800 in extra pre-tax medical contributions
  • Cons:
    • Have to deal with this plan for an extra year, which could be more expensive
    • Potentially roughly $1,000 in taxes and penalties

And if I stay conservative and just pay the prorated amount:

  • Pros:
    • No potential penalties
  • Cons:
    • Lose out on extra pre-tax savings

About the best I can come up with right now is to go with the full-year contribution amount and see how much the plan costs me. Then, next year when open enrollment rolls around, compare plans. If I’m likely to save more than $1,000 with another plan, I’ll switch and pay the penalty.

And then I’ll hope that I don’t switch jobs, and that my company continues to offer the same type of plan.

All this might not be quite as imbecilic as wandering a Walgreen’s in December trying to figure out what I can spend my excess FSA money on, but it’s certainly in the same spirit.

But enough about me. Have any of you dealt with this madness? How did you make your decision?

Mike Pumphrey

Mike Pumphrey

I'm the founder and author of Unlikely Radical, a site to help people succeed with money, achieve their goals, and live intentionally.

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Mike Pumphrey
Posted on December 7, 2017