Copyright© 2007 by School Services of California, Inc.

                                      Volume 20                   For Publication Date: February 16, 2007             No. 4

Ask SSC . . . 

What is the Effect of Health Savings Accounts
on State Income Taxes? 

Q.                I understand that state tax law has not yet been updated to coincide with federal law, which exempts Health Savings Accounts from income taxes. What is the practical effect of this for employees who have these accounts in California? 

A.                 Contributions made by the employer into the Health Savings Account (HSA) for an employee in California are tax exempt according to federal law (as long as certain requirements are met), but are taxable according to current California law. This means that the total amount of contributions from the employer into the employee’s HSA are reported on the employee’s Form W-2, and the employee’s taxable earnings for California purposes are increased by that amount. The employee ends up paying the California income tax on the employer’s contributions. 

            In addition, the employee will pay California income tax on any earnings resulting from the employer HSA contributions, even though the employer does not report these earnings on the employee’s Form W-2. 

            Now that, under a new federal law, there are certain additional transactions allowed, such as a rollover of funds from a flexible spending account into an HSA, these types of transactions would be taxable under California law as well.  

            There are currently several bills that have been introduced in the California Legislature to remedy these differences between federal and state tax law. Hopefully this will be accomplished during this legislative session.

—Sheila G. Vickers and Gina Will