The only time it makes sense to move funds from an IRA to an HSA
A little-known rule buried deep on the IRS website presents a once-in-a-lifetime opportunity for clients with a health savings account — the ability to make a contribution directly from an IRA.
Although this one-time offer isn’t worth the effort for most clients, who’d be better off continuing to fund both accounts and collect dual tax breaks for doing so, there are a handful of situations where cash-strapped clients with high medical costs could really benefit from making the move and tapping tax- and penalty-free funds.
What the rule says
Clients can move money from their traditional or Roth IRA account to their HSA using what’s known as a qualified HSA funding distribution. SEP and SIMPLE IRA assets can be used as well, but only if no employer contribution has been made in the same tax year as the HSA distribution.
To take advantage, a client must be currently enrolled in a high-deductible health plan and eligible to contribute to an HSA. Crucially, the HSA provider must initiate the transfer, at the client’s behest, directly from the IRA account.
The amount that can be moved over, however, remains limited to the same maximum as direct HSA contributions, meaning the most that can be deposited into the HSA from an IRA withdrawal this year is $3,550 for those with individual coverage, or $7,100 for family coverage. Those age 55 and older can add $1,000 to each of those figures thanks to catch-up contributions.
Clients with generous employers who contribute to their HSA or who have already stashed some money in the account this year will need to subtract this sum from those maximums to find the total they can transfer. Or alternatively, they can file a withdrawal of a mistaken HSA contribution form with the provider and try to remove whatever sum has already been deposited, paying income tax on it, says Roy Ramthun, founder and president of HSA Consulting Services and a former health care policy advisor for President George W. Bush.
Funds transferred to the HSA this way aren’t tax deductible, as with a normal direct HSA contribution. But they also can’t be counted as income — giving this move its edge over simply using money directly from an IRA for health care needs.
When it can help
Clients suffering large medical expenses in a single year without enough cash on hand or funds in their HSA to cover such costs typically benefit most from this transfer because it saves them incurring penalties or income tax.
With a traditional IRA, withdrawals would face income taxes and potentially a 10% early withdrawal penalty for those under age 59 ½, if unreimbursed medical expenses did not exceed 7.5% of a person’s adjusted gross income. The same money in an HSA could be taken out tax- and penalty-free for health care. (For Roth IRAs, this move is unhelpful, says Ramthun, as contributions may always be removed tax- and penalty-free, while earnings may also be if the account has been open for at least five years and the money is used for medical expenses or health insurance costs when unemployed or if taken out after age 59 ½.)
Financial planner Christopher Woods, founder of LifePoint Financial Group in Alexandria, Virginia, recently recommended this transfer to one of his clients, who was laid off from his job last year so began his own business in 2020. Since this client was earning little income and had already drained his HSA because of family medical expenses, with more health care costs still to pay, Woods felt it was the appropriate year to do this, adding, “this transfer can be a fantastic opportunity for people who can really benefit from it.”
Given the pandemic and recession, more clients than usual may find themselves in this boat of low income and high medical bills. For many, it might make more sense to take advantage of the CARES Act provisions for IRAs, which allows up to $100,000 to be deducted with income tax spread over three years and the option to repay the sum. However, since this rule ends on Dec. 31, clients still struggling may find this transfer a comforting backup option worth considering early next year.
High-deductible health plan newbies who have never had an HSA before might also benefit, financial planner Daniel Galli has found, especially if they are concerned about how they might cover their deductible in a catastrophic health year.
“The ability to ‘prime the pump’ in this first year by transferring over money from an IRA can help solve that concern,” says Galli, founder of Daniel J. Galli & Associates in Norwell, Mass. “The IRA transfer can also be helpful if the HSA hasn't been funded yet or is underfunded.”
Finally, this strategy might also make sense for clients who want to prepare for upcoming medical expenses but don’t have enough cash spare to fund the HSA in a given year, says Ramthun.
What to watch out for
Because this is a one-time only move, clients need to fully understand the transfer and use it only in special circumstances, says Woods. However, there is one loophole: If someone makes a qualified HSA funding distribution when they have individual coverage, but, later that same tax year, switches to family coverage, they can then make another transfer to reach the family contribution maximum.
Clients who don’t expect to remain on a high-deductible health plan much longer, intend to job hop, or enroll in Medicare shortly may get bitten badly by the IRS if they make this move. That’s because when assets transfer from an IRA to an HSA they are subject to what’s known as a “testing period,” which begins the month the distribution is made and ends about 13 months later, says Ramthun. Clients who drop their high-deductible coverage and become ineligible to contribute to an HSA in that time face income tax on the full transferred sum and a 10% additional tax.
The transfer can also take two to three weeks to complete so you should start the process before December. For Woods and his client, it took close to three weeks from submitting the transfer form to having the money in the HSA account, but Ramthun suspects that turnaround time might increase later in the year.