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I THOUGHT I HAD a pretty good handle on health savings accounts, or HSAs. My wife and I contributed to HSAs over the decade before we retired. The money we accumulated has come in handy in the early years of retirement. I’ve also written several articles extolling their virtues.
But I recently learned that we missed an opportunity to further fund these accounts, while simultaneously reducing future required minimum distributions. The trick is to do a rollover from an IRA to an HSA. The tax code allows a once-in-a-lifetime IRA-to-HSA rollover. This little-known strategy is called a qualified HSA funding distribution. It appears that Congress authorized this as a way for a taxpayer to access IRA funds for a onetime significant medical expense.
Direct rollovers are allowed from a regular IRA, but not from a SEP or SIMPLE IRA. You also can’t do a direct rollover from an employer-based account, such as a 401(k), 403(b) or 457. But you could roll over funds from your employer-based account to a rollover IRA, and then do the direct transfer to your HSA.
To contribute to an HSA, you must be enrolled in a high-deductible health plan, or HDHP. Contributions to HSAs are tax-deductible and any subsequent growth is tax-deferred. Withdrawals from your HSA that are used to pay qualified medical expenses are tax-free. This is unlike withdrawals from a traditional IRA, which are considered taxable income.
For individuals with an HDHP in 2023, the maximum contribution to an HSA is $3,850, while the maximum contribution for those with family coverage is $7,750. There’s an additional $1,000 catch-up contribution allowed for those age 55 and older. Consider a married couple, both 55 or older, with an HDHP through one spouse’s employer. In 2023, they could contribute up to $9,750—a $7,750 family contribution, a $1,000 catch-up for the insured and another $1,000 to the other spouse’s HSA.
Converting funds from a traditional IRA to an HSA, and then using them for future qualified medical expenses, has the effect of eliminating the tax owed on the sum involved. It also has the added benefit of shrinking your IRA balance and thereby reducing future required minimum distributions.
The maximum amount you can roll over is the same as that year’s HSA limits on contributions based on your age and type of coverage. In other words, any amount rolled over reduces the amount you can contribute directly to your HSA for that year. This includes any contributions your employer makes on your behalf.
The strategy is covered by strict rules, so you need to do your homework. The rollover is reported on line 10 of IRS Form 8889. One of the more complicated parts is the testing period. You must remain eligible for an HSA during a 12-month testing period, which begins in the month you make the rollover and ends 12 months later on the last day of that 12th month, with the distribution month counting toward the 12-month total.
Got that? For example, if you did a rollover on June 17, 2023, the testing period would end on June 30, 2024. If you fail the testing period—there are exceptions for death or disability—the entire amount that was rolled over becomes taxable income and subject to a 10% tax penalty.
Who does this make sense for? A good candidate would be a married couple, over 55, enrolled in a family coverage HDHP, with existing HSAs. Let’s assume the HDHP is through the wife’s employer. She could roll over the maximum amount—$8,750 in 2023—to her HSA. Her husband could also roll over $1,000 to his HSA, for a total of $9,750.
If the couple has individual HDHP health insurance coverage, they could each roll over the maximum individual amount into their own accounts. They can even share the maximum amount unevenly, but the IRS rules for splitting HSA contributions between a married couple are complicated, so you need to make sure you follow the rules carefully. Of course, a single person can also use this up to the individual maximum amount.
This once-in-a-lifetime conversion has the impact of a Roth IRA conversion, but without the current income tax burden. Adding an additional tax-free $9,750 to an HSA may not seem like a lot, but it could help cover some medical expenses if you’re an early retiree who isn’t yet age 65 and eligible for Medicare.
In addition, I could see using this tactic in conjunction with a Social Security claiming strategy, where the higher-earning spouse delays his or her benefit, while the other spouse claims earlier. The additional HSA funds could cover several years of a retiree’s future Medicare premiums, which are considered an eligible expense for tax-free HSA withdrawals.
Unfortunately, my wife and I missed the boat on this opportunity. Vicky retired in July 2021. I started Medicare in September 2022. During the intervening 13 months, we purchased an HDHP health plan through my old employer. We could have done at least a partial rollover, based on our months of coverage.
But who says you have to do a rollover? Researching the rollover strategy made me consider an alternative approach for some pre-Medicare retirees. Here’s how it might work:
Result? Their HSA contributions are tax-deductible and thus reduce their taxable income—and that means the IRA withdrawal is effectively tax-free.
Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.
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Thanks! I don’t recall ever hearing about this before. I’m on Medicare, so too late for me.
I’ll toss in one more clarification: Eligible expenses for HSA funds include Medicare Part B, but not Medigap, premiums.
I did a qualified H.S.A. funding distribution (HFD) for tax year 2010. I wish I had not done so.
When you made a HFD in 2010 your IRA custodian directly sent the distribution from your IRA directly to your HSA account and then issued you a 2010 1099-R showing the full amount amount of the HFD as a taxable distribution. The IRS could only become aware that the distribution is a HFD from my 1040 filing.
I electronically filed my 2010 1040 on 2/5/2011 showing the total IRA distribution on line 15a and the taxable amount of zero on line 15b and the software indicated next to line 15b that the distribution was a non taxable qualified HSA funding distribution with the IRS code “H” next to line 15a. Included in my return was also form 8889 noting on line 10 the distribution was a qualified HSA funding distribution. The IRA custodian and I properly followed the the filing instructions as detailed on page 47 of IRS Pub 590. The instructions to the 2010 form 8889, page 5, line 10 also states “This distribution is not included in your income, is not deductible, and reduces the amount that can be contributed to your H.S.A.”
This was exactly how the direct trustee-to-trustee was done and reported on my 2010 1040 return.
In June 2012 (sixteen months later) I received a CP2000 notice from the IRS wherein they proposed a tax balance due as “the third party information they received did not match entries on my 1040”. I responded to the notice and at the end of June 2012 received a response thanking me for my correspondence and advising me that they would contact me within 60 days to let me know what action they are taking. In August 2012 I received a CP2005 notice informing me that “We’re pleased to tell you that the information provided resolved the tax issue in question and that our inquiry is now closed” and that the amount due was $0.00.
In my many years before retirement as a CPA in public practice I had filed only one return reporting a qualified H.S.A. funding distribution, mine. In hindsight, deciding to make a qualified H.S.A distribution from my IRA was a waste of my time.
William, thans for reading and providing your cautionary tale. Apparently many folks weren’t aware of this option, including some IRS agents. IN the aerospace industry they try to embrace a “lessons learned” process to prevent future projects from making the same mistakes. It isn’t perfect, and depends too much on employees making the effort. Is it possible to find out if your experience did something like that for the IRS – do they try to spread knowledge so these kind of issues don’t happen again?
Good morning Rick,
I am unaware of any action the IRS took to resolve the issue I had in their system. Those taxpayers having returns reporting a qualified HSA funding distribution from a IRA are rare so I would guess that any action by the IRS in this area would be a low priority for the IRS.
The complexity of our tax code combined with last minute legislation by congress seems to me to make anticipation and implementation of a lessons learned process difficult for the IRS. Fortunately, the service does have tools to respond after the fact, even if those processes react slowly.
In addition to established paper, fax and telephone methods of responding to notices by taxpayers and their representatives the IRS seems to be moving to encouraging more efficient electronic methods. See https://www.irs.gov/individuals/understanding-your-irs-notice-or-letter
Additionally, there is the Taxpayer Advocate Service (TAS) which is an independent organization within the IRS to help every taxpayer to be treated fairly. The TAS advocates can help if you have tax problems that you can’t resolve on your own. I think it is a best practice to respond as soon as administratively possible to all IRS notices. The key to requesting help from the TAS is first responding through regular procedures.
Further, professional organizations, like the AICPA and state CPA organizations, often have standing committees which meet periodically with representatives of the IRS (and state tax agencies) to discuss and resolve systemic filing issues.
I try to keep my personal taxes as simple as possible to avoid the headaches that seem to follow complexity and recommend filing original returns electronically whenever possible to avoid inadvertent input errors.
Best, Bill
A good, well-organized examination of this topic.
This year, as I’m older than 59 1/2 but not yet on Medicare, I followed the option you describe toward the end of your article: I withdrew an amount from my IRA equal to my HSA contribution, with the goal of having the increased tax liability of the IRA withdrawal offset by the decrease in tax liability from the HSA contribution.
There were ancillary factors I considered before doing this. First, I had been making incremental IRA-to-Roth conversions already in modest amounts that were capped by my desire to stay within my current tax bracket. While this is a relatively pain-free way to bleed off an IRA balance over time, as a strategy it has a drawback: I’ve been doing these incremental conversions for 10 years but market returns in the IRA have been greater than the amounts of my conversions. That is, my IRA balance now is greater than when I started doing small annual conversions. So, for me, increasing the amounts withdrawn from my IRA without serious tax disadvantages was attractive.
Second, I did not need the HSA deduction to stay within my marginal tax bracket. Funding the HSA through current income rather than the IRA would have given me a tax deduction, but in neither case did the decision cause my marginal rate to change. There’s a chance that if the HSA deduction allows significant tax savings, it would be better in a given year to fund the HSA another way than through the use of IRA money. This might be particularly true for folks who are older than 59 1/2, but not yet on Medicare, and who are getting their health insurance through the ACA. That’s because the insurance premium for ACA coverage typically varies according to your income. For some people, using the HSA deduction might cut income and hence insurance premiums enough that the benefit of lower insurance exceed the benefits of reducing the IRA balance.
Third, my HSA allows for various investments through Fidelity, which offers options more wide-ranging than a simple savings account. The better your HSA investment choices (and they do vary from one plan administrator to the next) the more attractive this strategy is.
My wife’s employer’s HSA’s investment choices are lousy, and requires her to keep too much in cash, so we roll over her money to her Fidelity HSA once a year. We’ve even given up saving payroll taxes by contributing directly to the Fidelity HSA. The rollovers are only money contributed by the employer.
Randy, thanks for reading and commenting. Our original HSA accounts also had lousy choices. The company switched administrators and they added a number of low cost Vanguard funds which were much better. They still made you need a high amount in cash or charged annoying monthly service fees.
David, thanks for reading and for the excellent description of your thought process and decisions. I have been meaning to move my HSA to Fidelity for a number of years but haven’t done it yet.I agree the sweet spot for this might be in the 59 1/2 to 65 time frame, especially if one is retired, buying their own HDHP health insurance, and living on their assets and/or pension. This was our situation for about 18 months and would have been a good time to do the “once in a lifetime” transfer. Alas (as Jonathan would say), I wasn’t aware of it at the time.
I’d not heard of this. Good to keep in mind!
David, thanks for reading and commenting.
Would a Medigap Plan F or G high deductible count as a HDHP?
Kathy, thanks for reading. William is correct that once on Medicare you can not contribute to an HSA. As I said in the article this is an interesting strategy but applicable to a narrow group of folks.
I believe the answer to your query is no as the the ability to enroll in any Medigap plan is conditioned on first enrolling in Medicare. If you enroll in Medicare Part A and/or B, you can no longer contribute pre-tax dollars to your HSA. This is because to contribute pre-tax dollars to an HSA you cannot have any health insurance other than an HDHP.
Thanks for the clarification. I’ve never had an HSA, so am not up on the details.
Richard as I understand it I could either make an HSA contribution and get the deduction or I could roll-over a similar amount from my IRA and remove that money tax-free but not get a deduction? Next year I plan on getting the HSA deduction which will lower my MAGI. If I rolled over from the IRA I would get no deduction. So either get HSA deduction or do roll-over from IRA “tax-free” and get no deduction? Right?
James, that is correct. I would also take the deduction if I was still working. I think it makes sense when someone has retired and before they hit Medicare. I see it a bit like a stealth Roth Conversion- but you roll over into an HSA.
Good article, Rick. You’ve started an early morning family discussion about how we might use this information.
Hi Edmund, thanks for reading and commenting. I hope this helps you in some small way.
Hi Richard – great article to inform about this. For couples MFJ, does “the lifetime” apply to both taxpayers jointly or individually – the IRS instructions for Form 8889 states “You can make only one qualified HSA funding distribution during your lifetime.” e.g. is it possible for a husband and wife to each contribute $8750 from their respective IRAs over a two year period?
Alistair, thanks for reading and your kind words. I don’t believe that both spouses can do a full rollover. The $7750 is the maximum family amount, so it includes the one-year, one-time maximum for both spouses. The $8750 is equal to the $7750 plus a $1000 catch-up contribution for the insured spouse. The other spouse included on the family plan, if eligible, can make a separate $1000 rollover to their HSA. Sorry if that wasn’t clear.