Should You Transfer Money From an IRA to an HSA?

Anything that's billed as being "once in a lifetime" just tantalizes, doesn't it?

An around-the-world cruise. A trek to Machu Picchu. Dinner at a world-famous restaurant like Osteria Francescana. These are bucket list items that people look forward to--and remember--for years.

Similarly, the IRS website describes a "qualified HSA funding distribution"--transferring IRA assets to a health savings account--as something you can do only once in a lifetime. Based on that description, you might be inclined to think it's worthwhile to do such a transfer, and that you should strategize about the very best time to undertake it in order to maximize the benefit.

In reality, however, transferring money from an IRA to an HSA will be of limited value, except in a small handful of cases. Most other IRA owners should leave their IRA assets intact and fund their HSAs with non-IRA dollars, the better to maximize contributions to both account types and take advantage of tax-sheltered savings.

How It Works With a qualified HSA funding distribution, an individual transfers assets from his or her IRA to an HSA. SEP and SIMPLE IRA assets aren't eligible for such a transfer if an employer contributed to the SEP or SIMPLE IRA during the year in which the distribution to the HSA is to be made.

Importantly, the individual must be covered by a high-deductible healthcare plan for such a distribution to be allowable. (Just as you have to be covered by such a plan to fund an HSA, so the plan coverage is also essential when funding an HSA with IRA dollars.) The transfer must be done from "trustee to trustee"--in other words, the account holder shouldn't take possession of a check from the firm holding the IRA and send it to the HSA provider.

Any amount transferred from an IRA to an HSA isn't deductible (unlike a direct HSA contribution), but nor is it includible in income in the year in which it's distributed. That "not includible in income" piques interest, in that it allows traditional IRA assets that would otherwise be taxed upon distribution to be moved over to an HSA, where withdrawals for qualified healthcare expenses are tax-free.

Yet there are significant strictures surrounding the transfers. Specifically, the amount transferred to the HSA cannot exceed the HSA contribution limit for that year; if direct HSA contributions have already been made for that year, that limits the amount of IRA assets that may be transferred into the HSA. In 2018, the HSA contribution limit is $3,450 for individuals with high-deductible healthcare plan coverage and $6,850 for HSA contributors with family coverage. (Note that the IRS recalculated the family coverage HSA limit in early March, as discussed here; it was previously expected to be $6,900.)

When It May Be Useful The main instance when transferring IRA assets to an HSA might come in handy is if an individual has heavy, unforeseen medical expenses in a given year and not enough on hand or in the HSA or to cover them. Not only is the amount transferred from the IRA to the HSA not includible in income in the year the distribution occurs, but any money pulled from the HSA to cover qualified healthcare expenditures will be tax-free as well.

In such cases, the IRA to HSA transfer looks better than other means of paying those costs. A direct withdrawal from a traditional IRA would incur taxes, whereas money transferred to the HSA before being withdrawn and used for qualified medical expenses would not be subject to tax. Resorting to other means of financing--whether 401(k) loans or credit cards--carry their own financing costs. By contrast, the IRA to HSA transfer gives an individual who's covered by a high-deductible healthcare plan access to funds on a tax-free basis.

An IRA to HSA transfer might also make sense in the period leading up to retirement but prior to age 59 1/2, when an individual knows that he or she will have upcoming healthcare expenses but doesn't have ready assets to fund the HSA in that year. In that case, the advantage of transferring funds from the IRA to the HSA is that tax-free withdrawals will be available for HSA assets used for qualified healthcare expenses, but traditional IRA assets would be taxable in retirement regardless of their use.

Why It's Suboptimal Yet while the HSA qualified distribution might make sense in a narrow range of situations, it's suboptimal for a few reasons. First, ideally you'd leave your IRA assets undisturbed to grow for retirement, and you'd also fund your HSA directly, rather than boosting it with your IRA assets. At the risk of stating the obvious, contributing to each account separately increases the total amount contributed and also allows the direct contributor to take full advantage of the tax benefits associated with each account. A direct contribution to an HSA, for example, is tax-deductible, whereas money that gets into an HSA via the transfer is not.

Nor does the HSA qualified funding distribution make sense for people with Roth IRAs. Roth IRAs allow for withdrawals of contributions at any time and for any reason without taxes or penalties, providing a major escape hatch for people with heavy healthcare needs; there's no need to get the HSA involved. Moreover, in retirement Roth IRA assets enjoy the same tax treatment that HSA assets do, yet there are no strictures on what Roth IRA assets must be spent on to enjoy tax-free withdrawals.

Finally, a qualified HSA distribution won't make sense for job-hoppers or people who don't expect to remain covered by an HDHP. That's because those making a transfer of IRA assets to an HSA are subject to a "testing period," meaning that they must remain covered by a high-deductible healthcare plan for 12 months after the distribution. If you don't, the amount of the HSA distribution is considered includible in income, effectively negating the tax benefits you gained by doing the distribution.