June 1, 2023
IRAs-to-HSAs
Take-Away: The tax laws seem to be filled with quirks. One such quirk is the ability to take a qualified Health Savings Account (HSA) funding distribution from a traditional IRA. Yet, as with anything that deals with HSAs, the funding distribution can get complicated real quickly.
Background: A health savings account (HSA) can be funded with a qualifying IRA distribution. However, it is a once-in-a-lifetime opportunity for the HSA owner. The advantage from this funding strategy is that the funds, if taken from a traditional IRA, will end up in a much more tax-advantage account because HSAs are ‘triple-tax-free,’ which means that no tax is imposed on: (i) the contribution to the HSA; (ii) the growth of the assets held in the HSA; and (iii) a qualified withdrawal from the HSA.
Contribution Limits: The maximum amount that can be rolled over from the IRA to the HSA is capped at the amount of that calendar year’s HSA contribution limit. In addition, the amount of the rollover to the HSA reduces the owner’s HSA contribution limit for the year that the IRA distribution is made to the HSA. In other words, in order to avoid an excess contribution to the HSA, the account owner who has employer contributions, or who has already made contributions to the HSA in the rollover year, should limit their rollover amount from their traditional IRA to the contribution limit for the calendar year less any previous employer contributions and all other contributions to the HSA for that year.
Example 1: Beth, a single HSA account owner, is age 54. Beth is enrolled in an HSA-eligible heath care plan with individual coverage through her employer. Beth will be able to rollover from her traditional IRA only $3,850 in 2023 (the annual HSA annual contribution limit for 2023.) If Beth waits until she is age 55 years in which to make the rollover from her IRA, she will have an additional $1,000 that can be rolled into her HSA due to the ‘catch-up’ contribution rules.
Example 2: Beth has family coverage from her employer. Beth is age 55 years (or older.) Beth makes the qualified IRA rollover to her HSA at that age. In this instance, Beth can roll over $8,750 in 2023 to her HSA, since she has family coverage.
Example 3: Same facts as immediately above. Beth is married to Todd, also age 55. Todd is carried on Beth’s health insurance plan. Todd can also make a qualified $1,000 rollover from his traditional IRA to Beth’s HSA, thus giving the two of them almost $10,000 in eventual tax-free income from their IRAs rolled over to Beth’s HSA.
IRA Sources: A qualified rollover from an IRA to a HSA can be from either a Roth IRA or a traditional IRA. However, there cannot be any rollovers from ‘’ongoing SEP-IRA or SIMPLE IRA, where the employer contributes to the employee’s IRA in the same year as the qualified distribution is made to the HSA. Nor can such rollovers originate from a 401(k) account, although the plan participant could make a rollover from their 401(k) account to a traditional IRA, and then follow with a rollover from their traditional IRA to their HSA.
Roth IRA: It should come as no surprise that it would be best to use a traditional IRA, not a Roth IRA, for as the source for the qualified IRA distribution to the HSA. About the only time it might make sense to make the rollover from a Roth IRA is when funds are immediately needed by the account holder to pay medical bills without incurring high interest rates on those debts and the account holder wants to avoid the Roth IRA early withdrawal penalty.
Testing Period: Probably the biggest trap to avoid when a qualified HSA is funded with a distribution from a traditional IRA is the HSA ‘testing period.’ This requires that the account holder must be: (i) enrolled in an HSA-eligible plan at the time of the rollover and that (ii) the account holder must stay enrolled in an HSA-eligible plan for at least 12 months from the rollover date. If this two-step ‘test’ is not met, the entire IRA distribution will be included in the account holder’s taxable income and also subject to a 10% excise tax. If the account holder is approaching Medicare eligibility, and the IRA rollover is made less than 12 months before enrolling in Medicare, the individual’s enrollment will automatically disqualify any HSA contributions and they will not meet the ‘testing’ requirements. In short, if the IRA owner is nearing Medicare age eligibility of 65 years, and they want to fund their HSA with a qualifying IRA distribution, they will need to plan at least 12 months ahead of turning age 65 in which to implement their qualifying IRA rollover to their HSA.
Rollover Steps: The qualified HSA funding distribution must be initiated by the IRA custodian and performed in a trustee-to-trustee direct transfer. An indirect rollover where the account holder requests a distribution from their IRA custodian and then deposits the cash distribution amount in their HSA will not qualify, much like a qualified charitable distribution (QCD) made from their traditional IRA. All rollovers to the HSA must be done in cash. This qualified rollover is reported on Form 8889.
Conclusion: The triple tax savings using a HSA should not be overlooked. Moving IRA funds to the HSA with a qualified distribution is a step to get as many funds in the HSA as possible, while presumably reducing the account owner’s future taxable RMDs. There are just a few, albeit complex, rules to comply with in making the qualified distribution.