A reader asked me about the once-in-a-lifetime transfer from an IRA to an HSA, officially known as the qualified HSA funding distribution. It’s one of those things that just because you can doesn’t mean you should. In all likelihood you are better off not knowing this option even exists.
Still Must Qualify For HSA Contribution
In order to do the once-in-a-lifetime transfer from an IRA to an HSA, you still have to qualify for making a contribution to the HSA. That means having an HSA-eligible high deductible health plan with no other coverage.
Eat Into HSA Contribution Limit
The once-in-a-lifetime transfer from an IRA to an HSA does not increase your HSA contribution limit. The maximum you can transfer is your normal HSA contribution limit. It’s not on top of your normal contribution limit. If you do the transfer, it reduces dollar-for-dollar the amount you can contribute in other ways, either directly or through your employer.
No Tax Deduction
The transfer from your IRA to your HSA is not taxable, but you also lose the tax deduction you otherwise would get if you contribute normally. As a result, compared to just contributing normally, doing the transfer raises your AGI in the same way as taking a withdrawal from your traditional IRA except you don’t have to pay a penalty if you are under 59-1/2. Raising your AGI increases your taxes. It can make you lose other tax benefits.
Gotcha Testing Period
If you do the transfer you must also commit to staying with an HSA-eligible high deductible health plan with no other coverage for 12 months. If you fail the commitment, the transfer becomes taxable and you’d have to pay a 10% penalty. There’s no such requirement if you contribute normally unless you invoke the last-month rule in order to contribute more than you are allowed otherwise.
Once In A Lifetime
With so many restrictions the transfer is still limited to just once in a lifetime, of a few thousand dollars.
I really don’t know what the point is in pulling money from one account to another, raising your AGI, paying more taxes and putting yourself into a gotcha trap. The once-in-a-lifetime restriction makes it sound like an opportunity you shouldn’t miss. Actually it’s practically useless.
If you have other money you can use to make a contribution to your HSA, just use your other money. You lower your AGI and you reduce your taxes. Your IRA will continue to grow for your retirement.
If you absolutely have no other money to fund your HSA but you are already 59-1/2, you can just take a regular IRA withdrawal and simultaneously contribute to your HSA. The income on the IRA withdrawal and the tax deduction for the HSA contribution will create a wash. You can do it every year if you want to and there is no 12-month commitment.
If have no other money to fund your HSA and you are not yet 59-1/2, compared to just taking a regular IRA withdrawal to fund the HSA, doing the transfer from your IRA to your HSA amounts to a penalty-free, but not tax-free, withdrawal of a few thousand dollars from your IRA. The penalty relief is limited to just once in your lifetime, and it comes with gotcha strings attached. It’s not that useful. You are better off letting your IRA grow undisturbed.
In summary, doing the once-in-a-lifetime transfer from an IRA to an HSA is:
- better than withdrawing from the IRA but not contributing to the HSA (why would you not contribute?)
- better than paying a penalty to withdraw from the IRA when you are under 59-1/2 to contribute to the HSA (just use other money to contribute and leave your IRA alone)
- worse than doing a regular withdrawal from the IRA to contribute to the HSA (limited to once-in-a-lifetime, have testing period)
- worse than using money outside the IRA to contribute to the HSA (higher taxes; less health insurance subsidy)
Bottom line: forget about the one-time transfer from your IRA to your HSA.
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Bob Jackson says
Hi, Harry – I’m a big fan. I’m over 59.5 years old and have a lot of money in a pre-tax IRA. I want to reduce the pre-tax IRA balance to avoid future high RMDs. Three scenarios (w/simple numbers), all of which assume I have $30 of income annually:
1. Contribute $10 cash on hand to the HSA, do a $10 Roth conversion. Effect on gross income: $10. Effect on AGI: $0 (because the $10 Roth conversion raises my gross income to $40, and the $10k cash HSA contribution lowers my AGI back to $30). Effect on taxable income: $0. Effect on IRA balance: -$10.
2. Do a $10 QHSAFD. Effect on gross income: $0. Effect on AGI: $0. Effect on taxable income: $0. Effect on IRA balance: -$10.
3. Withdraw $10 from IRA, contribute that $10 to the HSA. Effect on gross income: $10. Effect on AGI: $0 (because the $10 IRA withdrawal raises my gross income to $40, and the $10 cash HSA contribution lowers my AGI back to $30). Effect on taxable income: $0. Effect on IRA balance: -$10.
The outcome on both (a) taxable income and (b) the IRA balance seems the same for all three scenarios. Given that I prefer not to use my cash to make an HSA contribution, the QHSAFD seems like the simplest solution from an administrative perspective (one transaction rather than two (or three, if I have to liquidate investments in my IRA to do the withdrawal)). Am I wrong? Thanks!
Harry Sit says
With (1), the $10 in cash goes into the Roth IRA. The future earnings on this $10 will be tax-free. With both (2) and (3), it’s left alone. The future earnings on this $10 will be taxable. (1) is the best for taxes but you don’t prefer it for unstated reasons. So we’re left with (2) or (3).
With (2), you can do it only one time. With (3), you can do it every year you’re eligible to contribute to an HSA. It reduces your pre-tax IRA more than (2) over multiple years. If you do (2) this year, what will you do next year? Back to (1)? Switch to (3)? Stop contributing to the HSA and give up the deduction? Why not do (1) or (3) every year?
Following the same process every year reinforces muscle memory. It’s less error prone.
Carl says
what about a young person who can only afford to fund $2k in today’s dollars to an individual HSA. Assume she will continue to fund that $2K + 3% for annual increases. If she has a traditional IRA and could afford to top off the HSA in year one to $4,300, taking advantage of the one-time rule. If that extra, one-time increased $2,300 contribution grows at 7% for 35 years, the ending value is $23.5k higher, or $8,276 discounted back to today (3% discount rate). So in present value terms, that seems like a slam dunk.
Finally, that terminal difference will not be taxed in retirement. That is an additional $2K in present value terms (actually higher than that if the money continues to grow during retirement)
Harry Sit says
As Bob showed in the comments above, doing the one-time transfer is the same as withdrawing from a traditional IRA to fund the HSA. The only difference between a young person and someone over 59-1/2 is the 10% early withdrawal penalty. If the young person in your example truly has insufficient money except in a traditional IRA, withdrawing $2,300 from the traditional IRA to fund the HSA costs $230. That’s the present value of a once-in-a-lifetime transfer, saving $230, which is a far cry from your $8,276 number plus an additional $2k or more.
The same question stands for our young person: What will you do next year? Find some money to fund the HSA? Withdraw from the IRA and pay the 10% penalty again? Fund less than the maximum? In any case, the $230 deal won’t be available again.
In the real world, people interested in the IRA-to-HSA transfer have money outside an IRA to fund the HSA, and people with no money outside an IRA to fully fund an HSA need all the money in their IRA for their retirement.