Using funds within an IRA (Individual Retirement Account)
to fund an HSA
(adapted from HSA Resources)
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.
-
Roth IRA or Nondeductible IRA - Basis Recovery:
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).
-
A Testing Period Applies on IRA to HSA Transfers:
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 Notes: The material discussed is meant for general illustration or
informational purposes only and is not to be construed as investment or tax
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 should be relied upon only when coordinated
with individual professional advice. We do not provide tax or legal advice].
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