Funding an HSA with an IRA: A Once-in-a-Lifetime Opportunity

A recent column mentioned the once-in-a-lifetime opportunity to fund an HSA with an IRA. Some of you followed up with questions about this unique transfer provision, known as a Qualified HSA Funding Distribution (QHSAFD). Let’s talk about this idea a bit more.

The concept is this: Once in a lifetime, an eligible individual can transfer funds tax-free from their Individual Retirement Account (IRA) to his or her Health Savings Accounts (HSA)—up to the contribution amount allowed for the year of the transfer. A QHSAFD is noteworthy because it allows traditional IRA assets that would otherwise be taxed upon distribution (and possibly a 10% penalty) to be transferred to an HSA, and subsequent distributions for “qualified medical expenses” are also tax-free!

How a QHSAFD Works

A QHSAFD is technically a direct transfer (“trustee-to-trustee”) from your IRA to your HSA, so to avoid an unexpected tax bill an account owner should not take possession of the funds (via a 60-day rollover and then later deposit funds in their HSA). And, as is always the case with direct contributions to an HSA, a person must be enrolled in a High Deductible Health Plan (HDHP) to facilitate a QHSAFD. While the transfer is not subject to income tax or the 10% early distribution penalty, the total amount transferred cannot exceed the amount you are eligible to contribute to your HSA for the year. Also, the amount transferred will be reduced by any HSA contributions, if any that were previously made throughout the year.

This opportunity does not include transfers from a 401(k) or any non-IRA based employer sponsored retirement plan (i.e. 403(b), 457(b) etc.) However, it is permissible to roll over a 401(k) or other retirement plan from a former employer to an IRA and, subsequently, transfer the assets to an HSA. The transfer is permitted from an individual’s IRA in which he/she is the account owner or from an inherited IRA in which he/she is the named beneficiary.

The QHSAFD must be made by December 31 because a QHSAFD relates to the taxable year in which the distribution is made. Prior year distributions are not permitted.

Examples

EXAMPLE 1: Tim, 48, has single only HDHP coverage. He may transfer up to $3,600 from his IRA to his HSA in 2021. In 2021, $3,600 is maximum HSA contribution limit for single coverage.

If Tim previously made direct HSA contributions (in the year of the transfer) it would reduce the QHSAFD transfer limit. Let’s say Tim previously made $1,000 in direct HSA contributions in 2021. Those contributions reduce his QHSAFD transfer dollar-for-dollar to $2,600 ($3,600 minus $1,000).

EXAMPLE 2: As mentioned, QHFDs are limited to once in your lifetime. However, there is a limited exception if you change HDHP coverage during the year – (i.e. begin the year with self-only coverage and then (during the same year) change to family coverage). In that case, the additional amount can be transferred in the same year.

Later in the (same) year Tim changes to family coverage. This change increases his QHSAFD maximum to $6,200 (The $7,200 family HSA funding maximum minus $1,000).

Good reasons to use a QHSAFD

Let’s say you are facing an unexpected and potentially expensive medical procedure. In that case, you can transfer otherwise taxable IRA funds to your HSA and then use the distribution to cover the qualified medical expenses associated with the medical procedure tax-free. Otherwise you would be looking at distributing funds directly from the IRA, which would generally result in taxable income plus a potential 10% early distribution penalty.
This is a nice way to start building your HSA nest egg by using the QHSAFD to kick start funding your HSA.
IRA basis (after-tax dollars) cannot be transferred via a QHSAFD. Therefore, this is a tremendous opportunity to transfer otherwise taxable IRA funds to your HSA while leaving after-tax funds in your IRA. Then, you can subsequently convert to a Roth IRA, reducing or potentially eliminating the tax burden. In other words, QHSAFD transfers are not subject to the IRS “pro-rata” distribution rule. Learn more here. - https://www.lordabbett.com/en/perspectives/retirementperspectives/how-to-avoid-being-taxed-twice-on-your-retirement-savings.html

Practice Tip: SEP and SIMPLE IRA assets aren't eligible for QHSAFD treatment if a contribution is made to a SEP or SIMPLE IRA during the year in which the transfer to the HSA is to be made.

Downsides of using a QHSAFD

This is truly a once-in-a-lifetime opportunity. With the maximum transfer amount limited to your HSA contribution for the year of the transfer. TIP: It’s best to do this when you either need it the most or you can contribute the most, preferably both.
Making direct contributions to an HSA is tax-deductible (federal and generally state), whereas funds transferred via a QHSAD --although tax-free-- does not get the benefit of being tax deductible.
It usually does not make financial sense to transfer Roth IRA assets to an HSA. Roth funds are generally withdrawn both tax and penalty free. Importantly, Roth IRA contributions can be withdrawn at any time regardless of age, reason or hold period without being subject to tax and or an early distribution penalty.
· It may not make sense if you’re considering switching coverage to a non-HDHP plan or changing employers – because QHSAFDs are subject to a "testing period," where you must remain an HSA eligible individual. Failure to remain an eligible individual during the testing period, for reasons other than death or disability, will result in the funds transferred being subject to income tax and potential penalties.

Learn more

There are other technical provisions associated with the QHSAFD, and we urge you to review available information if you are considering this opportunity. I also recommend that individuals engage a tax professional, in part because individuals are required to claim any associated tax benefits on their tax returns (there is no special 1099-R coding). See IRS Publication 969 “HSAs and Other Tax-Favored Health Plans”PDF Document for more information.

Key Takeaways:

A QHSAFD is a once-in-a lifetime and often overlooked opportunity to do a tax-free transfer from an IRA to an HSA. Subsequent distributions for qualified medical expenses are also tax-free.
The maximum you can transfer is limited to the amount of your HSA contributions for the year.
It’s wise to talk to your tax professional to help you determine if this is beneficial for you, as there are technicalities involved.

About the Author

Brian Dobbis, QKA, QPA, QPFC, TGPC

Retirement Solutions Lead

Important Information

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

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Health Savings Account is a tax-advantaged account created for or by individuals covered under high-deductible health plans (HDHPs) to save for qualified medical expenses. Contributions are made into the account by the individual or their employer and are limited to a maximum amount each year.1 The contributions are invested over time and can be used to pay for qualified medical expenses.

High Deductible Health Plan is a health insurance plan with a high minimum deductible. A deductible is the portion of an insurance claim that the insured pays out of pocket. Once an individual has paid that portion of a claim, the insurance company will cover the other portion, as specified in the contract. An HDHP usually has a higher annual deductible than a typical health plan, and its minimum deductible varies by year.

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as income. Amounts withdrawn from a traditional IRA are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies

Roth IRA is a tax-deferred and potentially tax-free retirement account available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

SEP IRA (Simplified Employee Pension) is a retirement plan that an employer or self-employed individuals can establish. The employer is allowed a tax deduction for contributions made to the SEP IRA and makes contributions to each eligible employee’s SEP IRA on a discretionary basis.

SIMPLE IRA is a retirement plan that may be established by employers, including self-employed individuals. The employer is allowed a tax deduction for contributions made to the SIMPLE. The employer makes either matching or nonelective contributions to each eligible employee’s SIMPLE IRA, and employees may make salary deferral contributions