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Health savings accounts: What you need to know to avoid an audit

Do you have a health savings account (HSA) through your health insurance? many types of policies now come with HSAs to cover out-of-pocket medical costs.

If you have a generous employer, you may receive $500 or $1,000 at the beginning of the year. In 2016, you can also contribute pre-tax earnings of up to $3,350 for a single person or $6,750 for a family to your HSA. You can invest any amount that you do not use on medical costs. In effect, these accounts can be used as retirement funds growing tax-free over the years.

A withdrawal for a non-medical costs, however, is taxed. If taken prior to age 65 there is also a 10 percent penalty. The Internal Revenue Service has several checks to ensure that HSA withdrawals are covering medical expenses.

Contributions to an HSA and legitimate medical expenses go on Form 8889. Your HSA should provide an end-of-year accounting that helps complete this form. Often people forget about these accounts and fail to discuss them with their accountant. 

Mismatch prompts an audit

The IRS is notified of any withdrawals via form 1099-SA. It is a red flag, if the agency matches this information against your return and finds no 8889. An HSA expense tax audit is the next step.

Receiving a letter from the IRS can be a panic inducing event, especially if it contains a past due tax bill. In this situation, the agency can only work off the information that it receives. Without an 8889 detailing legitimate medical expenses, the default is to tax any withdrawal and apply the penalty.

Avoid an IRS tax audit of your HSA expenses in a year with substantial medical costs by filling an 8889. If you receive an audit letter related to a prior tax year, speak with a tax attorney right away to resolve the matter.

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