I have a little experience with this. My home state of Wisconsin was on this list until 2011.
The thing to remember is that these states simply do not recognize the HSA. What this means is that there are no state income tax advantages to the account, and no state tax penalties, either.
Here are the implications:
- Contributions. Contributions that you deduct from your federal income need to be added back in to your income on your state return.
- Earnings. On your federal tax return, earnings such as interest and dividends inside your HSA do not need to be reported at all. However, these earnings need to be added in to your income on your state return so that you can pay state tax on them.
- Distributions. Distributions that are not spent on qualified medical expenses are subject to tax and penalties on your federal return. However, since the state does not recognize the HSA, there are no state tax and penalties due on any distribution from the HSA, no matter what you've spent the money on. Distributions that were added into your income on your federal return can be taken back out on the state return.
- Capital Gains. As far as the federal government is concerned, capital gains inside your HSA are free, and there is no need to track cost basis for investments inside your HSA. However, since your state does not recognize the HSA, any investing you do inside your HSA will be treated like an investment outside of the HSA on your state return. If you invest in securities inside your HSA, you will need to keep track of cost basis and pay state capital gains tax when you sell just like you would in a taxable account.
When you invest in a taxable account, your broker in many cases keeps track of cost basis for you. However, when you invest inside an HSA, your HSA custodian will generally not keep track of any of this, because it is not normally needed. Therefore, you need to keep track of any cost basis yourself, and when you sell, calculate the capital gain or loss on your state return.
In my opinion, the HSA is a good deal even if your state does not recognize it. The tax-free savings/investing is a great deal, even if only on your Federal taxes. The state return will be a little more complicated, but the savings you get on your federal return are worth it.
In my situation, our family spends the money in the HSA on medical expenses fast enough that we don't invest it in anything other than an interest-bearing savings account. Therefore, we didn't have to worry about capital gains inside our HSA, and only had to add contributions and earnings to our state income. I am very glad that our state now recognizes the HSA.