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Health savings accounts (HSAs) are the best retirement planning tool available, and there’s a little-known legal trick that can help fully fund an HSA.
An HSA has three powerful tax benefits. Contributions to the account are tax deductible when you make them, or excluded from gross income when an employer makes them. The account can be invested, and income and gains compound tax free in the account. When distributions are taken from the account to pay for qualified medical expenses, the distributions are tax free.
The annual contribution limit for an HSA in 2021 is $3,600 if you have individual health insurance coverage and $7,200 if you have family coverage. For people age 55 and older, an additional $1,000 catch-up contribution is allowed. To qualify for an HSA, you must have a qualifying high-deductible medical insurance policy. The deductible for individual coverage must be at least $1,400 and for family coverage the deductible must be $2,800.
Contributions to an HSA can’t be made after you’re a Medicare beneficiary.
If you want qualify for an HSA and want to fund it but are short of funds, you might be able to fund the HSA from your IRA using a qualified HSA funding distribution (QHFD).
In a QHFD, an individual has funds transferred (or rolled over) from an IRA to an HSA. The rollover, combined with any other contributions to the account during the year, can’t exceed the year’s contribution limit. The rollover is tax free. So, you’re able to move funds from your IRA to the HSA, which has even better tax benefits than the IRA.
There are some restrictions on the IRA-to-HSA transfer.
The most important restriction is that this is a one-time only rollover. It’s a once-in-a-lifetime limit per taxpayer, not per IRA. So, if you have multiple IRAs, you still can do only one QHFD during your lifetime. If one IRA doesn’t have enough funds to transfer as much as you want to the HSA, you first need to transfer enough funds from one IRA to another so that one IRA has enough funds. Then, you do one QHFD from one IRA.
A QHFD must be a direct trustee-to-trustee rollover. You can’t take a distribution and transfer it to the HSA yourself.
The QHFD can come from either a traditional IRA or Roth IRA or from an inactive SEP or Simple IRA. There’s no 10% early distribution penalty if you’re under age 59½.
But only pre-tax money can be transferred in a QHFD. That means if you want to transfer money from a Roth IRA only accumulated investment income can be transferred.
If you have nondeductible contributions in an IRA, they can’t be transferred to the HSA. The good news is the pro-rata rules don’t apply to QHFD. Under the pro-rata rules, whenever you have a distribution or rollover from an IRA that has nondeductible contributions, you can’t transfer only the pre-tax money. The transaction is considered to include a pro rata portion of the nondeductible contributions. With a QHFD, however, you transfer only the pre-tax money and leave the nondeductible contributions in the IRA.
Inherited IRA accounts can be used to make a QHFD. In addition, a QHFD counts toward any RMD from the inherited IRA for the year. That means someone who is beneficiary of an inherited IRA and has an RMD requirement can fund an HSA from the IRA and satisfy all or part of the RMD for the year with a QHFD.
You receive no tax deduction for the QHFD.
You must remain eligible for an HSA for 12 months after making a QHFD. If you lose HSA eligibility, then the QHFD becomes taxable.
When you’re looking for cash to maximize an HSA contribution for the year, consider an IRA. Despite the limitations, it might let you maximize the value of this powerful retirement planning tool.