California and New Jersey HSA Tax Return Special Considerations
After Alabama made its state law conform to the federal law, California and New Jersey are the only two remaining states that don’t recognize Health Savings Accounts. After reading my updated
I’m familiar with it, because I also live in California. Someone in New Jersey please point out how New Jersey works differently than California. If you live in other states, you don’t have to be concerned with this unless you are curious for a family member or you think one day you will come to live in the great state of California or New Jersey.
Contributions Through Payroll
Because the state of California does not recognize HSAs, your HSA contributions are not tax deductible for California state income tax.
If you are contributing through your employer, a properly configured payroll system will handle this for you. Your HSA contribution will be deducted from your gross pay for calculating the federal tax withholdings. It will not reduce your California state income tax withholding. If your employer contributes to your HSA, you pay California state income tax on that money as well.
After the year-end, the total HSA contributions (your own and your employer’s) will be excluded from the number on your W-2 box 1 Wages, tips, other compensation. As a result you don’t pay federal income tax on the HSA contributions. However, the total will be included in the number on your W-2 box 16 State wages, tips, etc. The difference between the higher number in box 16 and the lower number in box 1 will go as an adjustment on the California state income tax return, on Schedule CA (540), line 7, column C Additions.
Tax software usually handles this automatically when it sees different numbers in those two boxes on your W-2.
After-Tax Contributions On Your Own
If you contribute to the HSA on your own with after-tax dollars, the HSA contributions you fill out on IRS Form 8889 becomes a negative adjustment to income on your Form 1040. On the new draft form, it’s on line 25 of Schedule 1. Your federal AGI is reduced. You pay less federal income tax.
However, on your California state income tax return, because your federal AGI is reduced, you have to back out that deduction. This is done on the Schedule CA (540), line 25, column B Subtractions.
Tax software also usually handles this automatically when you have an entry on line 25 of your federal Form 1040 Schedule 1.
Earnings Inside The HSA
Because the HSA earnings are tax-free at the federal level, the HSA provider won’t send any 1099 for the earnings. Those earnings are still taxable by California. You have to go into the HSA account statements and tally up all the earnings during the year. This includes all interest and dividends paid inside the HSA.
The HSA earnings again must be included on the Schedule CA (540), column C Additions. If you use tax software, you have to figure out how to make the software do it. If you use a tax preparer, make sure you give the HSA earnings to your tax preparer and make sure the earnings are included on Schedule CA (540), column C Additions.
Realized Capital Gains Inside The HSA
When the investments inside your HSA distribute capital gains, or when you sell investments inside your HSA for more than what you originally paid, the gains are not taxable at the federal level. The HSA provider won’t send any 1099 for the gains. In order to calculate the gain or loss on each sale correctly for California state income tax, you have to track very carefully every purchase and sale inside the HSA, including all the reinvested dividends and interest.
After you calculate the gain and loss on each sale during the year, you add them up. If the total is a gain, you include the gain as a positive adjustment on Schedule CA (540), column C Additions. If the total is a loss, you include the loss — up to a limit — as a negative adjustment on Schedule CA (540), column B Subtractions.
The limit of the negative adjustment is your federal capital gains plus $3,000.
- Suppose you had $1,000 in capital gains on your federal income tax return, you can take up to $4,000 in California capital loss as a negative adjustment to your California income. If you have a higher loss than that, you will have to carry the remainder to future years.
- Suppose you already took $3,000 in capital loss against your income on your federal tax return, you can’t take any additional California capital loss. All the California capital loss must be carried over to future years.
By the book you are supposed to file Schedule D (540) to reconcile the additional California capital gain or loss. However, because California does not tax capital gains any differently from ordinary income, whether it’s a long-term gain or a short-term gain, I take a shortcut. I just lump the capital gains together with the dividends and interest paid inside the HSA as Other Income for California in the tax software. I don’t think they will have a problem with me treating [positive] capital gains as ordinary income. If you are able to do it by the book, do it by the book.
If I have a loss instead of a gain, I can’t do this lumping because there are limits on how much loss I can take as a negative adjustment to income. Because of this complexity, I just don’t sell when I have a loss.
Only Treasury Bond Funds In HSA?
Due to the additional tax complexity when you have an HSA as a California resident, some people suggest investing the HSA money only in Treasury bonds or Treasury bond funds. Interest paid by Treasury bonds are exempt from state income tax. Limiting yourself to only Treasury bonds or Treasury bond funds will spare you from worrying about paying California tax on the earnings inside the HSA. But, it won’t make it any easier for capital gains. Capital gains on Treasury bonds or Treasury bond funds are still taxable by the state. You still have to track all your purchases and your sales. You will have more tracking when you reinvest interest.
Investing only in Treasury bonds or Treasury bond funds in the HSA helps a little bit on the distributed earnings, but it doesn’t relieve the bigger hassle of tracking purchases and sales. Adding up the total distributed earnings during the year isn’t that difficult after all. Many financial institutions report the total interest and dividends paid on the statements.
Make Your Life Easier
In theory, for California state income tax purposes, having an HSA is just like having any other taxable account. Having to pay California tax on earnings and capital gains isn’t a reason for not investing in the HSA. The meticulous investors would just use software or a spreadsheet to track all purchases and sales as they always do for their taxable accounts. In practice, for everyone else, not having 1099s from the HSA provider for the sales makes it difficult to calculate capital gains.
Now that we know tracking purchases and sales for calculating capital gains is the bigger issue, we can do these to make our lives easier:
1. Don’t automatically reinvest interest and dividends. Making frequent small purchases will increase your burden of tracking. Just keep the interest and dividends in cash and use them to reimburse some medical expenses. I reimburse the previous year’s medical expenses before I invest the rest of the HSA money. See previous post
2. Buy just one fund. The fewer investments you have in the HSA, the easier it is to track. Even if you contribute through payroll and you invest new money throughout the year, when you have only one fund, you can treat all purchases as one, like this:
- Number of shares owned as of 12/31 prior year: 123.45
- Total basis as of 12/31 prior year: $2,000
- Number of shares owned as of 12/31 this year: 234.56
- New shares purchased this year: 234.56 – 123.45 = 111.11
- New money invested this year: $3,000
- Total basis as of 12/31 this year: $2,000 + $3,000 = $5,000
3. Don’t sell. If you don’t sell, you won’t have a capital gain or loss. No capital gain or loss, no extra reporting on the gain or loss. You still need to track purchases, because one day you may need to sell.
4. Don’t sell when you have a loss. Selling at a loss requires additional reporting and possibly carrying over the excess loss to future years. It just adds to the hassle. There is no deadline for reimbursing medical expenses. Wait until you have a gain.
5. If you must sell, sell all shares purchased in one specific year. To continue the previous example, if you must sell in the future, sell 111.11 shares purchased in a year as one unit. You know the basis associated with those 111.11 shares was $3,000. Doing so makes it easier to update your remaining basis.
- Number of shares owned as of 12/31 prior year: 234.56
- Total basis as of 12/31 prior year: $5,000
- Number of shares sold: 111.11
- Basis for the shares sold: $3,000
- Number of shares owned as of 12/31 this year: 198.76
- New shares purchased this year: 198.76 – (234.56 – 111.11) = 75.31
- New money invested this year: $2,000
- Total basis as of 12/31 this year: $5,000 – $3,000 + $2,000 = $4,000
It’s unfortunate that California doesn’t make it easy for us. Before the state changes the law, if you follow the practice above, you will have a much easier time in reporting California taxes for your HSA.
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