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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