Question: Which states tax HSAs at the state income tax level, and how does that affect employers?
Compliance Team Response:
General Rule: HSAs are Triple-Tax Advantaged
HSAs offer an unparalleled three tiers of federal tax savings:
- Pre-Tax Contributions
- Employee contributions through payroll are made on a pre-tax basis through the Section 125 cafeteria plan
- Employee contributions outside of payroll receive an above-the-line tax deduction
- Employer contributions are tax-free to the employee
- Tax-Free Growth
- HSA gains are not subject to interest, dividend or capital gains taxes
- Tax-Free Distributions
- Distributions for qualifying medical expenses are not subject to taxation
State Income Tax Exceptions: California and New Jersey
Almost all of the states conform to the federal income tax treatment for state income taxes (or they do not impose a state income tax, which makes this issue irrelevant). This means that in almost all states, employees will receive the same triple-tax advantaged benefit of HSAs for both the federal and state tax income purposes.
However, there are two states that do not conform to the federal tax-advantaged treatment of HSAs:
- California; and
- New Jersey
Note: Alabama was a third state in the past, but it recently conformed to the federal income tax treatment of HSAs as of 2018.
Therefore, although employee contributions to an HSA will be pre-tax for federal income tax purposes, contributions will be after-tax for state income tax purposes in California and New Jersey. Employees will also not receive the same tax-free growth as provided at the federal level.
The employer responsibility with respect to California’s and New Jersey’s HSA taxation for state income tax purposes is fairly simple. Employer and employee HSA contributions through payroll are simply treated as taxable income to the employee for state income tax purposes. This means the contributions are subject to state withholding and payroll taxes, and reported as taxable state income on the Form W-2 (Box 16).
Payroll systems are typically designed to address this automatically with very little effort by the employer. Most employers and employees tend to consider this state income tax issue to be a more of a minor annoyance than a factor in deciding whether to offer a HDHP to California and New Jersey employees.
- Jackie is a California employee who is enrolled in family coverage through his employer’s HDHP.
- In 2019, he contributes $4,000 to his HSA through payroll.
- His employer contributes $3,000 to the HSA.
- Jackie’s employee and employer HSA contributions through payroll are pre-tax and tax-free respectively for federal income tax purposes.
- However, the employee and employer HSA contributions are standard taxable compensation for California state income tax purposes, subject to state withholding and payroll taxes.
- Jackie will also use California Schedule CA to report the taxable income from interest and dividends.
Employers with employees in California and New Jersey should be aware of the state income taxation required for HSA contributions.
For more details, see our ABD Office Hours Webinar: Go All the Way With HSA.
(a) Deduction allowed.
In the case of an individual who is an eligible individual for any month during the taxable year, there shall be allowed as a deduction for the taxable year an amount equal to the aggregate amount paid in cash during such taxable year by or on behalf of such individual to a health savings account of such individual.
(d) Contributions to health savings accounts.
(1) In general.
In the case of an employee who is an eligible individual (as defined in section 223(c)(1)), amounts contributed by such employee’s employer to any health savings account (as defined in section 223(d)) of such employee shall be treated as employer-provided coverage for medical expenses under an accident or health plan to the extent such amounts do not exceed the limitation under section 223(b) (determined without regard to this subsection) which is applicable to such employee for such taxable year.
Prop. Treas. Reg. §1.125-1(a)(3)(j):
(3) Qualified benefit. Except as otherwise provided in section 125(f) and paragraph (q) of this section, the term qualified benefit means any benefit attributable to employer contributions to the extent that such benefit is not currently taxable to the employee by reason of an express provision of the Internal Revenue Code (Code) and which does not defer compensation (except as provided in paragraph (o) of this section). The following benefits are qualified benefits that may be offered under a cafeteria plan and are excludible from employees’ gross income when provided in accordance with the applicable provisions of the Code—
(A) Group-term life insurance on the life of an employee in an amount that is less than or equal to the $50,000 excludible from gross income under section 79(a), but not combined with any permanent benefit within the meaning of §1.79-0;
(B) An accident and health plan excludible from gross income under section 105 or 106, including self-insured medical reimbursement plans (such as health FSAs described in §1.125-5);
(C) Premiums for COBRA continuation coverage (if excludible under section 106) under the accident and health plan of the employer sponsoring the cafeteria plan or premiums for COBRA continuation coverage of an employee of the employer sponsoring the cafeteria plan under an accident and health plan sponsored by a different employer;
(D) An accidental death and dismemberment insurance policy (section 106);
(E) Long-term or short-term disability coverage (section 106);
(F) Dependent care assistance program (section 129);
(G) Adoption assistance (section 137);
(H) A qualified cash or deferred arrangement that is part of a profit-sharing plan or stock bonus plan, as described in paragraph (o)(3) of this section (section 401(k));
(I) Certain plans maintained by educational organizations (section 125(d)(2)(C) and paragraph (o)(3)(iii) of this section); and
(J) Contributions to Health Savings Accounts (HSAs) (sections 223 and 125(d)(2)(D)).
(a) General rule.
For purposes of this subtitle, the term “adjusted gross income” means, in the case of an individual, gross income minus the following deductions:
(19) Health savings accounts.
The deduction allowed by section 223.
What are the benefits of an HSA?
You may enjoy several benefits from having an HSA.
- You can claim a tax deduction for contributions you, or someone other than your employer, make to your HSA even if you don’t itemize your deductions on Schedule A (Form 1040).
- Contributions to your HSA made by your employer (including contributions made through a cafeteria plan) may be excluded from your gross income.
- The contributions remain in your account until you use them.
- The interest or other earnings on the assets in the account are tax free.
- Distributions may be tax free if you pay qualified medical expenses. See Qualified medical expenses, later.
- An HSA is “portable.” It stays with you if you change employers or leave the work force.
California Revenue & Taxation Code §17131.4:
Section 106(d) of the Internal Revenue Code, relating to contributions to health savings accounts, shall not apply.
California Revenue & Taxation Code §17131.5:
Section 125(d)(2)(D) of the Internal Revenue Code, relating to the exception for health savings accounts, shall not apply.
N.J. Stat. §54A:6-24:
Gross income shall not include the value of an employee’s qualified option under a cafeteria plan if the employee does not elect to receive cash and the value of the option is excludable from federal taxable income.
As used in this section:
“Cafeteria plan” means an employee benefit plan that meets the requirements of section 125 of the federal Internal Revenue Code of 1986, 26 U.S.C. 125;
“Qualified option” means an option to receive cash in lieu of a qualified employer-provided benefit which option may only be exercised if the employee derives a substantially similar benefit from a source other than the employer;
“Qualified employer-provided benefit” means a benefit the value of which is excludable from federal taxable income under a cafeteria plan but which is not a benefit provided pursuant to a salary reduction agreement; and
“Salary reduction agreement” means an agreement between an employer and an employee under which the employee individually chooses to reduce the employee’s compensation, or to forgo increases in compensation, and to have the amount provided, as an employer-provided benefit, by the employer to the employee; including but not limited to the agreements commonly known as flexible spending accounts and premium conversion options.
The New Jersey Gross Income Tax law does not adopt the federal income tax treatment of cafeteria plans as provided under I.R.C. Section 125. However, the New Jersey Gross Income Tax law has a very limited exclusion for one particular type of cafeteria plan, not including any salary-reduction plan. Since the New Jersey exclusion is limited, the value of cafeteria plan benefits typically is includable in New Jersey taxable wages and subject to Gross Income Tax withholding.
Act 2016-345, HB109, grants a deduction on the Alabama Individual Income Tax return for contributions made to health savings accounts on or after January 1, 2018, in an amount to coincide with the annual deduction amount for health savings account contributions allotted by federal law.
EFFECTIVE DATE: Effective for taxable years beginning after December 31, 2017.
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).