Understanding HSA testing periods, penalties

Health savings accounts allow individuals to set aside tax-free dollars to pay for qualified medical expenses. As such, it makes sense to most people that they would lose this tax benefit and pay an additional penalty if they use HSA money for an ineligible expense, similar to the tax and penalty they would pay for an early withdrawal from an IRA or 401(k). The penalty increases from 10 percent to 20 percent beginning with the 2011 tax year and is calculated on IRS form 8889, which HSA account holders are required to complete.

Taxpayers do not actually have to send their receipts to the IRS to prove that the money spent out of their HSA was for qualified expenses – unlike an FSA or HRA, substantiation of claims is not required. Instead, the individual keeps records of his or her medical expenses and self-reports to the IRS whether a penalty applies or not. He will need to produce these records if he is ever audited.