I was initially pleased to learn about California’s pending legislation, SB 230, currently under committee review, which aims to align California’s tax treatment of Health Savings Accounts (HSAs) with federal guidelines for tax years 2025 through 2030. At present, California and New Jersey are the only two states that do not conform to federal HSA treatment, while 48 states do.
In general, California nonconformity creates many complications for tax professionals, ranging from mildly inconvenient to significantly burdensome. This was particularly evident during the COVID-19 pandemic, when rapid changes to federal tax law often left tax professionals in California waiting until the last minute to determine the state’s stance on conformity—whether it would be full, partial, or none.
By way of background, federal tax law (Internal Revenue Code Section 223) provides eligible individuals with a high-deductible health plan the ability to contribute to an HSA. Contributions to the HSA, up to an annual limit that is indexed for inflation, are tax deductible as an adjustment to Adjusted Gross Income (AGI), often referred to as an “above-the-line” deduction. Withdrawals from an HSA for qualified medical expenses are tax-free. Furthermore, funds within an HSA can be invested in income-producing assets such as stocks or bonds, with any earnings remaining tax-exempt as long as they are either retained in the HSA or withdrawn for qualified medical expenses.
California has never conformed to federal HSA treatment, so any HSA deduction on a taxpayer’s federal income tax return necessitates an addback for purposes of California taxable income. Additionally, it is important to note that earnings within an HSA, including interest and dividends, are subject to California taxation. This nuance is often overlooked and may lead to considerable compliance challenges.
Given these complexities, I was optimistic about the prospect of the California legislature addressing this issue for the upcoming tax years.
Unfortunately, upon closer reading of the bill (as amended March 15, 2023), there is an adjusted gross income (AGI) threshold – $87,000 for married filing jointly (MFJ) and $42,000 for single filers. Taxpayers with incomes exceeding these thresholds for any tax year would not benefit from HSA conformity. Federal law has no such AGI thresholds.
This would make an already confusing area of nonconformity even more head-spinning. If a taxpayer has income that fluctuates around the AGI threshold but keeps contributing to an HSA year after year, this would create different taxable and tax-exempt California-only “basis” layers within the HSA. If these funds were invested in income-producing assets, then some of the earnings might be taxable and some might not be.
This bill is still in the Assembly, so there are no guarantees that it will become law. However, it serves as a notable example of how legislative bodies, despite their best intentions, may introduce complications that create unintended compliance and record-keeping burdens for their constituents.
*Please note that the information provided in this blog is for general informational purposes only and does not constitute legal, tax, or financial advice. The tax treatment of Health Savings Accounts (HSAs) can vary based on individual circumstances and state-specific laws. Before making any decisions regarding your HSA, it is important to consult with a qualified tax professional who can provide guidance tailored to your specific situation.
