The HSA Distribution Rules: Part II

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The HSA Distribution Rules: Part II

By Brian Gilmore | Published February 27, 2025

Question: What are the HSA distribution rules?

Short Answer: HSA distributions for unreimbursed qualifying medical expenses are tax-free where incurred after establishing the account by HSA owners or their eligible dependents. Individuals can also roll over or transfer HSA balances to another custodian without tax consequences. Non-medical distributions are subject to ordinary income tax and (if under age 65) a 20% additional tax.

Note: This is the second in a two-part series addressing the HSA distribution rules.

Part I: The HSA Distribution Rules

Starting Point: Only HSA-Eligible Individuals Can Establish and Contribute to an HSA

Health Savings Account (HSA) eligibility is required for any individual to establish an account and make or receive HSA contributions. Individuals must satisfy the following four requirements to be HSA-eligible:

Be covered by a qualified high deductible health plan (HDHP);
Have no other disqualifying health coverage;
Not be enrolled in any part of Medicare; and
Not be able to be claimed as a dependent on someone else’s current-year tax return.

Section 223 of the Internal Revenue Code imposes annual HSA contribution limits that adjust each year for inflation. Each individual’s limit is based primarily on whether the individual is enrolled in employee-only vs. family HDHP coverage, whether the individual is age 55+, and the number of months HSA eligibility in the year.

For more details:

Qualifying Medical Expenses Must be Incurred After HSA Established for Tax-Free Distribution

Individuals may take a qualified tax-free medical distribution from an HSA only for medical expenses incurred after the individual has established the HSA. State trust law determines when an HSA is considered "established." Most state laws require that a trust be funded to be established. This means that in most cases an HSA is not established until a contribution is deposited.

Example 1:

Juba is hired November 15 by Proximo and Associates with date of hire coverage.
He enrolls in the company’s HDHP medical plan option.
Juba did not establish an HSA previously.
On November 20, Juba incurs $250 in deductible expenses under the HDHP medical plan option.
The first deposit into Juba’s HSA is made by Proximo and Associates in December.

Result 1:

Juba’s HSA is established in December.
Juba cannot use the HSA to pay for his $250 deductible expenses on a tax-free basis because they were incurred prior to the December establishment of the HSA.
Note: Juba also is not HSA eligible (i.e., eligible to make or receive HSA contributions) in November because he was not covered by the HDHP as of the first day of the calendar month.

For more details: HSA Establishment Date

Special HSA Establishment Rule: Individuals Who Had an HSA in the Previous 18 Months

For individuals who previously had an HSA, there is a significant exception from the general rule that may permit individuals to take a tax-free medical distribution prior to the date the new HSA is funded. The special rule provides that the new HSA is deemed to be established when the first HSA was established as long as the individual had an HSA with a balance greater than zero at any time during the 18-month period ending on the date the new HSA is established.

Example 2:

Juba is hired November 15, 2025 by Proximo and Associates with date of hire coverage.
Juba enrolls in the company’s HDHP medical plan option.
Juba had an HSA previously that was established January 2024.
Juba distributed the last funds from that previous HSA on July 4, 2024, leaving no account balance.
On November 20, 2025 Juba incurs $250 in deductible expenses under the HDHP medical plan option.
The first deposit into Juba’s new HSA is made by Proximo and Associates in December 2025.

Result 2:

Juba funded his new December 2025 HSA within 18 months of the date he last had a balance in his prior HSA (July 4, 2024).
Juba’s new HSA is therefore deemed established January 2024 (instead of December 2025).
Juba can use the new HSA to pay for his $250 deductible expenses on a tax-free basis because they were incurred after the new HSA’s deemed establishment date in January 2024.

The HSA Shoebox Rule

HSAs offer an additional unique feature to further enhance its triple-tax advantaged status: The ability to delay taking a tax-free medical distribution for years while enjoying tax-free growth in the HSA. There is no requirement that a tax-free HSA distribution be taken in the same year that the medical expense was incurred.

IRS guidance confirms that as long as the requirements are followed, “there is no time limit on when the distribution must occur.” ( IRS Notice 2004-50, Q/A-39). This concept of saving medical receipts for HSA distributions taken in future years is commonly referred to as the "Shoebox Rule," in reference to the use of a shoebox for the safekeeping of such records.

The HSA Shoebox Rule Requirements:

The expense was incurred after the HSA was established;
The individual keeps records sufficient to later show that the distributions were exclusively to pay or reimburse qualified medical expenses;
The qualified medical expenses have not been previously paid or reimbursed from another source; and
The medical expenses have not been taken as an itemized deduction in any prior taxable year.

Example 3:

Gracchus established his HSA prior to 2025.
He incurs $1,400 in expenses for the deductible under his 2025 HDHP.
Gracchus also pays $600 out-of-pocket (i.e., not covered by insurance or reimbursed by any account) in 2025 for new prescription glasses and the cost-sharing for a new dental crown.
He does not take any of these expenses as an itemized deduction.
He does not pay for any of these expenses directly from his HSA, preferring instead to use his credit card and receive cash back reward points.
Gracchus keeps the records of his $2,000 in medical expenses incurred in 2025 stored in a shoebox.

Result 3:

Gracchus can take a $2,000 distribution from his HSA in 2025 to reimburse himself for the medical expenses he incurred that year.
Alternatively, Gracchus could utilize the HSA Shoebox Rule and wait until a later year (e.g., 2026, 2036, 2050, etc.), to reimburse himself for the $2,000 in medical expenses he incurred in 2025.
Delaying reimbursement for multiple years provides additional opportunity for the tax-free growth of Gracchus’s HSA funds (invested in stock/bond mutual funds through his HSA custodian).

For more details: The HSA Shoebox Rule

Loss of HSA Eligibility Does Not Affect Ability to Take Tax-Free Medical Distributions

Individuals do not have to maintain HSA eligibility (i.e., the ability to make or receive HSA contributions) to take tax-free distributions for medical expenses. HSA eligibility is relevant only for determining the ability to make or receive HSA contributions—not for purposes of taking tax-free medical distributions.

This means an HSA owner can:

Build up an HSA balance, move to non-HDHP coverage in a subsequent year, and still use that HSA (after losing HSA eligibility) to pay for qualifying medical expenses tax-free; and/or
Incur but not reimburse qualifying expenses while HSA-eligible, move to non-HDHP coverage in a subsequent year, and still use that HSA (by preserving the shoebox of health receipts) to reimburse those expenses incurred while HSA-eligible.

Example 4:

Gracchus moves to non-HDHP coverage and loses HSA eligibility as of 2026.
He has a remaining HSA balance of $5,000 from his five prior years of HSA eligibility.
Gracchus incurred $2,000 in qualifying medical expenses in 2025 that he has not reimbursed from his HSA or any other source, and he stores the receipts for such expenses in his shoebox.

Result 4:

In 2026 or any future year after losing HSA eligibility, Gracchus can continue to incur medical expenses and take tax-free medical distributions from his HSA to pay for such expenses.
In 2026 or any future year after losing HSA eligibility, Gracchus can reimburse himself for the $2,000 in 2025 health expenses incurred (preserving the records saved in his shoebox).
The only consequence of Gracchus’s loss of HSA eligibility is that he cannot make or receive HSA contributions in 2026 or any future year unless he regains HSA eligibility.

Prohibition of Double Dipping

The IRS imposes a blanket prohibition against using any account-based health plan for an expense that has been reimbursed from another health plan. The guidance stems from Section 105, Section 125, Section 213, Section 223, as well as IRS Notices, Information Letters, and Publications. The prohibition also extends to tax deductions. Individuals who have an expense reimbursed by a health plan (whether account-based or traditional) cannot claim that same expense as a deduction on their tax return.

The practical result is that any expense reimbursed by the health plan, another account-based plan, or any other arrangement, cannot be reimbursed from the HSA as a tax-free qualified medical expense distribution. Using both the HSA and the health plan to reimburse an expense is the classic prohibited form of double dipping (i.e., the prohibited tax-advantaged reimbursement of the same expense more than once).

For more details: The HSA/FSA/HRA Double Dipping Prohibition

HSA Rollovers and Transfers

Although employers typically require that employees establish an HSA with the employer’s designated HSA custodian to make or receive HSA contributions through payroll, in almost all circumstances the employee’s HSA is not an employer-sponsored plan and is therefore not subject to ERISA. The result is that employees have complete ownership and control of the HSA as their own personal account, and DOL guidance prohibits employers from limiting the ability of employees to roll over or transfer their funds to another HSA. Employees can freely move their accounts to any other HSA custodian via a rollover or transfer.

HSA Rollovers: 60-Day Rule and One-Per-Year Rule

An HSA rollover occurs where the employee receives a distribution from the original HSA account and then re-deposits the assets in a second HSA established by the employee with a different custodian. There are two main rules associated with HSA rollovers:

60-Day Rule: The employee must deposit the rollover assets in the second HSA within 60 of its distribution from the original HSA; and
One-Per-Year Rule: The employee can make only one rollover contribution to an HSA during each one-year period.

HSA Transfers: No Annual Limitations

An HSA transfer occurs where the original HSA custodian directly moves the HSA funds to the second HSA established by the employee with a different custodian. The employee has no access to the assets in the transfer process and therefore is not responsible for completing the process within a set timeframe. HSA transfers are also frequently referred to as a “direct transfer” or a “trustee-to-trustee transfer.”

Outside the practical limitations described below, there are no limits on the number of HSA transfers an employee can complete. The once-per-year rule for HSA rollovers does not apply to an HSA transfer because the employee does not have access to the funds in the process.

Practical Limitations on HSA Rollovers and Transfers

Although employees may prefer another HSA custodian, there are a few practical limitations on how frequently they may choose to move assets to another HSA custodian:

The HSA bank may require a minimum balance to avoid fees;
It can be administratively burdensome for employees to complete paperwork to roll over or transfer HSA funds on a frequent basis;
The HSA bank may apply fees to each rollover or transfer to another HSA.

For more details: HSA Rollovers and Transfers

An Uncommon Form of HSA Transfer: Qualified HSA Funding Distributions (QHFDs) from an IRA

HSA eligible individuals are permitted to make a tax-free transfer from an IRA to an HSA once-per-lifetime. The IRA owner and HSA owner must be the same person, and the process must be handled via a transfer directly from the IRA custodian to the HSA custodian (i.e., rollovers are not permitted). These IRA to HSA transfers are referred to as “Qualified HSA Funding Distributions” or “QHFDs.”

QHFDs count as contributions when applying the general HSA contribution limit and the catch-up limit for the year in which the transfer occurs. There is also no option to designate a QHFD for the prior year if made by April 15 as with a standard HSA contribution—the QHFD will always apply to the contribution limit for the actual year in which the transfer occurs. A special testing period requires the individual making a QHFD to maintain HSA eligibility for 12 months following the transfer. The QHFD amount will become taxable for individuals who fail to remain HSA-eligible during the 12-month QHFD testing period.

Estate Planning Considerations

HSAs permit the HSA holder to designate a beneficiary to receive the account’s funds upon the HSA holder’s death. If the HSA holder fails to designate a beneficiary, the HSA will generally pass to the HSA holder’s estate.

If the HSA holder designates a spouse as the HSA beneficiary, the HSA passes to the spouse without change upon the HSA holder’s death. The spouse assumes the HSA without any taxation, and the HSA preserves the same tax-advantaged status as an HSA for the spouse.

If the HSA holder designates any individual other than a spouse as the beneficiary (e.g., domestic partner or children), the HSA will lose its tax-advantaged status upon the HSA holder’s death. This means that the account ceases to be an HSA, and the fair market value of the account becomes taxable to the beneficiary in the year of the HSA holder’s death. The non-spouse beneficiary can reduce the taxable amount by any payments made by the beneficiary for the HSA holder’s qualifying medical expenses incurred prior to the HSA holder’s death. Such payments must be made by the beneficiary within one year of the HSA holder’s date of death to qualify for the reduction.

If the beneficiary is the HSA holder’s estate (whether by designation or default), the HSA loses its tax-advantaged status and ceases to be a HSA upon the HSA holder’s death. In this case, the fair market value of the HSA upon death is included in the HSA holder’s taxable income for the deceased HSA holder’s final tax return.

For more details: What Happens to an HSA Upon Death

Summary

Thus concludes our tour of the HSA eligibility, contribution, and distribution rules. HSAs are a uniquely triple-tax advantaged arrangement that makes the account stand out among the variety of options employers may offer. The catch (because there’s always a catch) is the HSA rules can be unintuitive and somewhat complex, at least for those uninitiated with the structure. With any luck, this series of posts addressing the common HSA questions, concerns, issues, strategies, opportunities, and pain points helps provide an overview of how to tackle these everyday scenarios and Go All the Way With HSA.

Disclaimer: The intent of this analysis is to provide the recipient with general information regarding the status of, and/or potential concerns related to, the recipient’s current employee benefits issues. This analysis does not necessarily fully address the recipient’s specific issue, and it should not be construed as, nor is it intended to provide, legal advice. Furthermore, this message does not establish an attorney-client relationship. Questions regarding specific issues should be addressed to the person(s) who provide legal advice to the recipient regarding employee benefits issues (e.g., the recipient’s general counsel or an attorney hired by the recipient who specializes in employee benefits law).