The law has allowed IRA to HSA
transfers since the beginning of 2007; however, only recently did the IRS
release its extensive guidance, IRS Notice 2008-51, covering the rules for
moving money from an IRA to an HSA.
The concept is relatively simple:
take money out of an IRA tax and penalty free and put that money into an HSA.
This rule gives many Americans a needed source of funds for their HSAs outside
of their current income. Similar to a lot of tax laws; however, the relatively
simple can become moderately complex once the details are in place. Plus, the
concept sounds better than it really is. Only a small percentage of individuals
that ask about this option are best served by moving funds from an IRA to an HSA.
Who can fund an HSA with
an IRA?
Only individuals that are
eligible for an HSA can do this - not everyone that has an IRA. This rule alone
excludes all but a small percentage of Americans from taking advantage of this
new law. Additionally, an individual must have a permitted type of IRA and the
law only allows one IRA to HSA funding per lifetime.
There is an exception to the
once-per-lifetime rule if an individual changes from single High Deductible
Health Insurance (HDHP) coverage to family HDHP coverage in the same year of the
initial IRA to HSA funding. In this case, the individual is allowed one
additional IRA to HSA funding transfer to increase the contribution amount up to
the family HDHP limit.
What types of IRAs can
be used?
Only certain types of IRAs are
permitted: traditional IRAs, Roth IRAs and sometimes SEP IRAs and SIMPLE IRAs.
SEP and SIMPLE IRAs are not permitted if they are "ongoing" plans, meaning the
employer is continuing to fund the plans. SEP and SIMPLE are permitted if they
have not received an employer contribution for the plan year ending with or
within the tax year of the IRA funding. An HSA owner cannot fund an HSA with a
401k directly. An individual may be able to do a rollover from a 401k to an IRA
and then move the assets to an HSA.
How much money can an
HSA owner move from the IRA to the HSA?
The maximum an individual can
move from an IRA to an HSA is their federal HSA limit for the year: $2,900 for
individuals and $5,800 for families for 2008, plus a catch-up of $900 if the
person is between ages 55-65. The IRA to HSA transfer cannot exceed the federal
limit and counts against the federal limit. Individuals do not get the IRA to
HSA funding in addition to other contributions. Accordingly, individuals need to
coordinate the IRA to HSA amount along with any employer contribution, payroll
deferral, or other direct HSA contributions for the year to make sure the
combined amount does not exceed the federal limit.
What is the tax impact?
IRAs and HSAs are creations of
the tax code and the main reason to complete an IRA to HSA funding should be tax
driven. If nothing else, this rule gives taxpayers a method to avoid paying
taxes and penalties on an IRA distribution necessary to pay medical expenses.
The IRA to HSA contribution is
not tax deductible. This makes sense because the distribution from the IRA is
treated as a "qualified HSA funding distribution" and is not subject to taxes or
penalty (if an early withdrawal). Individuals do not pay taxes on the IRA
distribution therefore they do not get to claim that tax deduction for the
subsequent HSA contribution.
Essentially individuals
are trading one tax-favored account, the IRA, for another, the HSA.
Sound financial advice generally
encourages individuals to maximize their tax-favored accounts. With that goal in
mind, a common recommendation would be to keep an IRA as is and fund an HSA with
other funds to maximize contributions to tax deferred accounts. By using other
funds, an individual will get a federal income tax deduction for the HSA
contribution and protect the IRA for the future. The IRA to HSA funding option
will generally appeal to individuals that do not have other funds available to
put in the HSA.
Whether the HSA is a better
account depends upon the individual’s circumstances.
HSAs and IRAs share many of the
same tax attributes; however, the HSA is arguably a better spot for money than
an IRA from a tax perspective. The key difference is that the HSA can be used to
pay for medical expenses tax free and the IRA cannot.
Even this basic difference
requires examination if the individual is using a Roth IRA to fund the HSA,
rather than a traditional deductible IRA because Roth IRA contributions can be
withdrawn tax and penalty free.
The decision to move money
from an IRA must be made only after a careful review of both the circumstances
and the law to determine if it is appropriate.
The tax situation becomes more
complicated if an individual moves money from a Roth IRA or a non-deductible
traditional IRA with basis. For the purposes of an IRA, basis is the amount in
an IRA that is not subject to taxes when it is distributed because it never
received an income tax deduction when initially contributed.
All contributions to Roth IRAs
are after-tax and have basis. The earnings in a Roth IRA or non-deductible
traditional IRA are tax-deferred, meaning the earnings grow federal income
tax-free until distributed. The IRA to HSA rules allow the entire basis to
stay with the IRA where it can be recovered at the time of distribution from
the IRA. No basis transfers to the HSA.
This is very favorable
treatment, albeit a bit complex to track. If an individual does not have
enough non-basis money in an IRA and still chooses to move the money into the
HSA, the individual loses the basis in that amount moved into the HSA.
Individuals in this case should seek professional tax guidance because losing
basis could have serious tax consequences. Still, in limited circumstances, it
may make sense to move funds with basis into an HSA. For example, if someone
is facing a large medical bill with no other method to pay it, the transferred
IRA money will very quickly be used to pay medical bills from the HSA. The
basis issue in this case becomes somewhat moot as the money will not be taxed
anyway because it is used to pay an eligible medical expense. A person in this
position may be just as well served taking the money directly from the Roth
IRA and using it to pay medical expenses. Individuals are allowed to take
non-qualified distributions from a Roth IRA without tax or penalty so long as
no earnings are returned (the return of basis following Roth IRA basis
recovery rules).
Individuals that move money
from an IRA to an HSA are subject to a testing period. They must maintain HSA
eligibility for the twelve months following the transaction. For example, if
an individual moves money from an IRA to an HSA on August 5, 2008, the testing
period will begin on August 1, 2008 and end on August 31, 2009. The individual
must remain eligible for the HSA that entire period or the amount of the IRA
to HSA transfer is subject to taxation and a 10% penalty. If the individual
loses HSA eligibility due to death or disability, they will still pass the
test.
How does the IRA to HSA
transaction take place?
The money must move as a "direct
transfer." This means that the IRA owner cannot gain direct access to the funds.
Generally the direct transfer occurs by the IRA custodian or trustee working
directly with the HSA custodian or trustee to send the funds directly. It is
permissible for the IRA custodian to make out a check payable to the HSA
custodian for the benefit of the HSA owner and have the HSA owner hand carry the
check to the HSA custodian. There just can be no constructive receipt of the IRA
funds; hence, the direct trustee/custodian to trustee/custodian is the preferred
method of funding an HSA with IRA funds.
Please contact us for
more information or assistance with such matters at: 1.800.482.5347.
Disclaimer: The material discussed
herein
is meant for general illustration or informational purposes only and is
not to be construed as investment advice.
Although the information has been gathered from sources believed to
be reliable, it is not guaranteed. Please note that individual situations
can vary; therefore, the information contained herein should be relied upon only when
coordinated with individual professional advice. We are not licensed for
and therefore do not provide tax or legal advice.
