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I recently started an HSA. For federal income taxes this is a great deal because I get to contribute pre-tax and take tax-free distributions for medical expenses, or after age 65 I can take distributions with income tax like a 401(k).

However, I'm a resident of California, and they don't adhere to the federal rules for HSAs. For contributions, it's pretty straightforward, I just have to add that income back to be taxed at the state level. Additionally, according to Instructions for Schedule CA (540):

Interest or other earnings earned from a Health Savings Account (HSA) are not treated as taxed deferred. Interest or earnings in a HSA are taxable in the year earned.

So will my brokerage send me 1099s for interest, dividends, and capital gains in my HSA?

Further, let's say I turn 65 and take a distribution. California can't tax that money again, right? But what if I retire to another state with state income tax that doesn't tax HSA contributions or earnings? And although this doesn't apply to me, what about the opposite, if I were a resident of another state that adheres to the federal rules for HSAs, but then retired in California. Would I be able to avoid all state income tax on contributions, earnings, and distributions after age 65?

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This is why California tax code is even more messed up than the Federal - they take the Federal and then add some. Or remove. Or mix up.

Whether your brokerage will send 1099 or not is up to the brokerage. Its a Federal requirement. California may require them to send it out for CA residents, or may not. They may adhere to the FTB, or may not. It doesn't matter to you.

You'll have to keep track of the interest and dividends received, cost basis for the securities, etc etc., just as any other brokerage account. You cannot rely solely on the information on the 1099 anyway, since it doesn't include many things you have to take into account for your Federal tax return as well, wash sales (inter-brokerage) being the most obvious example.

As to what happens when you're 65 - you'll have to keep track, again, of all the taxes paid, and track your California basis in the account, and your Federal basis in the account, and they will not be the same. Reconciliation time again when you get there. What a mess.

If you move to another state - the taxes you paid to CA are "lost". Similarly, if you move in to California, all the gains prior to moving in are not taxed by California. Whatever happens after - is taxed by CA as if it was a regular investment account.

  • A few clarifications: (1) Why would one need to track their federal basis in an HSA? (2) Does California tax distributions from an HSA? – Craig W Nov 9 '13 at 0:24
  • @CraigW (1) for the only reason its different from California. It doesn't (or, more likely, isn't expected to) change. (2) Since the income is recognized currently, distributions are post-tax (in CA) and shouldn't be taxed by the state. For CA income tax purposes this just another investment account. – littleadv Nov 9 '13 at 0:56
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    @CraigW BTW: You might want to call your representatives in the state legislature about this: leginfo.legislature.ca.gov/faces/… This has been introduced, and then silently killed, every session since the Federal IRC changed to allow HSAs – littleadv Nov 9 '13 at 0:59
  • it looks like you are saying distributions are taxed in California. Do you want to edit that? – Craig W Nov 11 '13 at 14:50
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    I think any logical reading of "whatever happens" would include distributions. – Craig W Nov 13 '13 at 19:31

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