June 23, 2008

New IRS Guidance on Transfers from IRAs to HSAs

In 2006, the Internal Revenue Code was amended to permit individuals to transfer funds on a tax-free basis from individual retirement accounts (IRAs) to health savings accounts (HSAs). Now, the IRS has issued guidance on how these transfers will work. (IRS Notice 2008-51.) The guidance is effective retroactively for taxable years beginning after December 31, 2006.

Generally, distributions of deductible IRA contributions are taxable, and, if distributed prior to the account owner's attainment of age 59 1/2, are subject to a 10% penalty unless an exception applies. However, "qualified HSA funding distributions" from an IRA are not subject to federal income tax or penalties, so long as certain conditions are met:

  • The individual making the qualified HSA funding distribution must remain eligible to contribute to an HSA for the entire "testing period," beginning with the month in which the distribution is made and ending on the last day of the 12th month thereafter. If the individual ceases to be eligible to make HSA contributions during the testing period, the entire amount of the IRA distribution will be subject to the IRA income taxation rules and the 10% penalty, if applicable.
  • The amount transferred to the HSA through a qualified HSA funding distribution cannot be deducted on the individual's taxes and counts against the individual's maximum annual HSA contribution for the taxable year of the IRA distribution. The HSA rule allowing contributions made by an individual's tax filing deadline to be treated as made in the preceding tax year does not apply to qualified HSA funding distributions.
  • Distributions can be made only from traditional and Roth IRAs (not ongoing SIMPLE or SEP IRAs).
  • The distribution must not exceed the IRA account owner's maximum annual HSA contribution for the year the transfer occurs, based on the coverage level (self-only or family) in place on the date of the distribution.
  • Only one qualified HSA funding distribution is allowed during an individual's lifetime—with one limited exception. If the distribution occurs when the individual has self-only high deductible health plan coverage and later in the same taxable year, the individual has family high deductible health plan coverage, the individual may make a second qualified HSA funding distribution in that taxable year.
  • Qualified HSA funding distributions must be made as direct transfers from an IRA to an HSA—the funds cannot be paid to the IRA account owner.

If the distributing IRA contains after-tax contributions (nondeductible Traditional IRA contributions or Roth IRA contributions), special rules apply when determining the individual's tax basis in the IRA following the qualified HSA funding distribution. Generally, the qualified HSA funding distribution is treated as coming first from the IRA amount that would be taxable upon distribution. The normal IRA pro-rata basis recovery rules generally do not apply.

The IRS Notice also clarifies that qualified HSA funding distributions are not subject to federal income tax withholding. HSA and IRA vendors may need to update their HSA and IRA documents to reflect this new IRS guidance.


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