Did you know that you can, in fact, move money, penalty and tax-free, from an individual retirement account (IRA) to a health savings account (HSA)? Yep, it’s true! This is called a qualified HSA funding distribution, or QHFD. But there’s a catch: you can only do this one time… ever.
You might be thinking, what’s the point? We’ve sure got answers! To start, the rollover allows you to fund your HSA immediately to pay for medical expenses. And there are, of course, tax savings for later… that is if you put off spending the funds until retirement when you can withdraw the money tax-free. But more on that in a bit.
If we had to guess, the question you’re probably asking yourself right about now is: How do I know if this one-time transfer is right for me?
Let’s find out.
The Tax Advantages at Retirement
In a traditional IRA, individuals contribute pre-tax dollars to a retirement account where investments grow tax-deferred for as long as you keep it in the account. Contributions may be 100% or partially deductible, depending on whether you or your spouse is covered by a retirement plan at their place of employment, and if your income exceeds certain levels.
When you’ve hit retirement, the money you invested in your traditional IRA is subject to income tax upon withdrawal. The IRS requires you to take out a required minimum distribution (RMD) at the age of 72.
But that’s not so with an HSA! Funds withdrawn from your HSA for eligible medical expenses are never taxed, before or after retirement. Plus, you’re not restricted to use the money sitting in your HSA before or after a certain age. It’s yours to use, whenever. This arrangement also means that you can watch your HSA fund grow year after year when you invest. Pretty awesome.
If you don’t touch the rolled-over funds until retirement, you’ll get a sweet tax benefit.
This is a lot to take in. To help you better understand, we’ve broken it down in an example.
Say you’re 55 years old in 2020. You roll over the maximum of $8,100 (if you have an HSA set to the annual family contribution limit) from your traditional IRA to your HSA. Assuming your HSA grows at a 4% return over 10 years (until age 65), at that time you’ll have $11,990 to spend on eligible medical expenses, tax-free.
In comparison, let’s say you took no action and left that $8,100 in your traditional IRA. With the same 4% rate of return over 10 years, you would have $10,191 after paying taxes (at a 15% marginal rate). And instead of a tax-saving boost, you would have missed out on $1,799. Such a waste!
What are the Rules for the One-Time Transfer?
When you complete a one-time transfer from your traditional IRA to your HSA, keep these rules in mind.
- You can make this super tax-genius move only once in a lifetime, so do it when you either need it the most or when you will be able to contribute the most—or preferably both!
- You can transfer the amount equal to the annual HSA contribution limit, minus any contributions you’ve already made.
- For 2020, the limits are $3,550 for single health coverage and up to $7,100 for family coverage. If you turn 55 in the calendar year, lucky you—celebrate your birthday by making an additional $1,000 catch-up contribution 😉
- You won’t be penalized with a tax bill or early withdrawal charges.
- You must continue to be enrolled in an HDHP for 12 months after the transfer. If you don’t, you will be liable for a tax penalty.
But before you click the “transfer” button, heads up! There’s something else you need to know.
For people who can afford to, it’s better to maximize your contributions in both the HSA and the traditional IRA. After all, we are talking about ratcheting up your retirement savings! So if you can make new contributions to your HSA, then do it! You’ll benefit from tax-deductible contributions there while also leaving the traditional IRA funds to grow tax-deferred.
Note: as of this writing, the world in the throws of navigating COVID-19, or the novel coronavirus. The pandemic has people concerned about their future, both in regard to their physical and financial wellbeing. HSAs are often described as a “rainy day fund” or an emergency fund for healthcare expenses, and for good reason.
As the situation around COVID-19 continues to evolve, we urge you take advantage of this triple-tax-advantaged account in order to better prepare yourself for the future. If you’d like to learn more about how to best use your HSA during this time here.
Of course, decisions are up to you (always!), and whatever suits your financial situation best. Happy saving!