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Funding an HSA with an IRA

Although the ability to move funds from an IRA to an HSA is limited, it can be a valuable way to deploy IRA funds

Sep 17, 2019 @ 1:07 pm

By Jamie Hopkins

Millions of Americans fund a health savings account each year. If the account is through their employer, it's likely funded through automatic payroll deductions.

But most people aren't aware of a rule that lets them fund an HSA with their individual retirement account. Although fairly limiting, the rule is a valuable way to deploy IRA funds.

Let's take a closer look and find out when it's beneficial to roll an IRA into an HSA.

The Health Opportunity Empowerment Act of 2006 allows individuals to roll over funds from an IRA to an HSA without having the funds taxed or included as taxable income.

For this to happen, the money must be rolled over directly into the HSA. In other words, clients can't have the IRA send them a check for them to deposit in your HSA.

Additionally, if they decide to go this route, they need to remain eligible for their HSA for 12 months following the transfer — known as the testing period.

[More: Why healthy clients need to save more for retirement]

Limitations exist

The single biggest limitation on this HSA funding strategy is individuals can only roll over from their IRA into an HSA once in their entire lifetime. Yes, that's correct, only once. On top of that, the amount they can roll over is limited.

The table below spells out the caps placed on yearly HSA contribution amounts for an individual and a family. An additional $1,000 catch-up is available for those who are age 55 or older.

Both spouses can do the annual catch-up, but each would have their own HSA as HSAs can't be jointly owned.

The maximum an individual could contribute to an HSA in 2019 would be $7,000 if they met the high-deductible health plan rules for a family, plus the additional $1,000 for being 55 or older, for a total of $8,000.

Contribution maximum (Individual) Contribution maximum (Family)
2019 $3,500 $7,000
2020 $3,550 $7,100
Source: shrm.org

Since the rollover rule applies once per person, a spouse could roll over their IRA to an HSA the next year if the couple still met the eligibility rules.

So a couple 55 or older could transfer a total of $16,000 over two years under this rule. And even though an HSA is individually owned, the withdrawn money can be used to pay for the health care expenses of anyone in the family.

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When's the timing right?

When should individuals consider funding their HSA with an IRA rollover? The clear-cut time is when they're eligible for an HSA, don't have enough money to fund it, but have enough money saved up in their IRA.

Since HSAs allow funds to grow tax-deferred and allow the distributions to come out tax-free if used for qualified health care expenses, the tax treatment on distributions can be better than that of a traditional IRA.

However, if people have the money to fund an HSA, they should do that. They're likely better off funding rather than rolling over their IRA since their contribution will also be tax-deductible. This allows them to set more money aside in a tax-advantaged vehicle than if they just used the IRA rollover to fund the HSA.

[More: The black hole of financial planning: Health care costs]

Another cool wrinkle of the rollover strategy is that you can't roll over nondeductible or after-tax contributions from your IRA to an HSA. This allows you to transfer your taxable money to the HSA and increase the nontaxable percentage of your IRA if you happen to have nondeductible contributions in there.

It's a strategy only available for IRAs. Roth IRAs are included, but it's not a good idea to roll over a Roth IRA to an HSA since the Roth is already receiving tax-free gains. Additionally, you can only use taxable amounts so it would have to be with Roth gains, not contributions. As such, using a Roth IRA to fund an HSA appears to be a very poor strategy.

It is possible to transfer money from a 401(k) to an HSA, but the funds would need to be rolled over into an IRA first.

Ideally, individuals would want to implement this strategy before you reach retirement. Once you're on Medicare Part A or Part B, you're no longer eligible to contribute to an HSA and the rollover strategy is no longer available.

The rollover strategy is very limited but can be very beneficial — so beneficial that the government should look into expanding HSA capabilities and funding strategies, as health care costs are one of the biggest concerns of retirees. It could open up HSAs to all working individuals — and not just those who have a high deductible health plan.

The government should also consider making a change to allow unlimited rollovers from IRAs to HSAs to help fund annual contributions and for IRA distributions to come out tax-free if used for qualified health care expenditures.

All of these changes would help individuals save more for retirement and provide tax benefits for saving and paying for health care costs.

However, the downside is any of these policy changes would likely decrease tax revenue, so the government would need to find a way to offset the lost revenue.

HSAs are valuable tax, health care and retirement planning vehicles. While the ideal scenario would be to fund your 401(k), IRA and HSA each year, many Americans don't have enough funds to do so.

To maximize tax benefits in the years when they can't fund everything, people need to make decisions. There's a lot to consider when it comes to saving for retirement and figuring out which account to use.

The benefit of funding an HSA with an IRA is clear. IRAs are great retirement savings vehicles, but their distributions are subject to ordinary income taxes. HSAs offer tax-free distributions.

Funding their HSA with an IRA is a great strategy that could save individuals a significant amount of money, if done correctly. The hard part is figuring out when's the right time to do it.

[More: Can HSAs flip the script on retirement health care expenses?]

Jamie Hopkins is director of retirement research and vice president of private client services at Carson Group.

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