Retirement Savings
ComplianceTax & AccountingNovember 11, 2021

Qualified Health Savings Account funding distributions: Funding a Health Savings Account with an IRA distribution

Overview

A qualified Health Savings Account (HSA) funding distribution allows for a “once in a lifetime” tax-free movement of money from an individual retirement account (IRA) to an HSA owned by the same individual. The HSA contribution is treated as a regular, current year contribution. The maximum amount an individual can move from his/her IRA to an HSA is whatever that individual’s HSA regular contribution limit is for the year the IRA distribution occurs.

IRA restrictions

A qualified HSA funding distribution may be made from a traditional IRA or a Roth IRA, but not from an ongoing Simplified Employee Pension (SEP) IRA, or Savings Incentive Match Plan for Small Employers (SIMPLE) IRA. A SEP IRA or SIMPLE IRA is considered ongoing if an employer contribution is made to the respective IRA for the plan year that a qualified HSA funding distribution would occur.

The amount must be distributed from one IRA. Therefore, if an individual wants to use funds from multiple IRAs, the amount must first be combined into a single IRA, usually using the IRA-to-IRA transfer process. An IRA owner will make a one-time qualified distribution from that IRA.

A beneficiary of a traditional or Roth IRA is eligible to take a qualified HSA funding distribution from an inherited IRA to fund his/her HSA. Any required death distribution amount(s) must be taken prior to the qualified HSA funding distribution.

Once in a lifetime option

An individual can use funds from an IRA to fund an HSA just one time during his/her lifetime. However, if a qualified HSA funding distribution is made when an individual is covered by a self-only High Deductible Health Plan (HDHP), and by December 1 of the same year that individual’s HDHP coverage changes from self-only to family coverage, the contribution limit increases. In this case a second qualified HSA funding distribution can be done allowing for the increased HSA contribution amount, considering it is done during the same calendar year.

Taxation and reporting

Distributions from IRAs are reported to the IRS on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. There is no unique IRS distribution code to identify that the funds are going into an HSA, essentially meaning that distributions under the qualified HSA funding distribution provision are reported based on the IRA owner’s age (i.e., prior to age 59½ or 59½ older). If a traditional IRA contains nondeductible contributions or after-tax dollars, the pretax amount of the IRA funds are the first amounts to be distributed. The after-tax basis comes out last. It is the responsibility of the IRA owner to track the IRA basis. The distribution from the IRA is not taxable. It is the IRA owner’s responsibility to claim exemption from tax on his/her federal income tax return.

The HSA contribution is reported on Form 5498-SA, HSA, Archer MSA, or Medicare Advantage MSA Information as a regular contribution for the year the IRA distribution was taken (i.e., no prior year HSA contributions when funding an HSA with a tax-free IRA distribution). A qualified HSA funding distribution is not eligible to be claimed as a tax-deductible HSA regular contribution.

The process

If an individual’s IRA and HSA are at the same financial organization, the organization will likely require the individual complete forms to document both the IRA distribution and HSA contribution. The funds are then directly transferred from an IRA into an HSA. If an individual’s IRA and HSA are held at different financial organizations, the IRA custodian may require the HSA custodian complete and send a Request for a Qualified Health Savings Account Funding Distribution form for the funds. After receiving the request form, the IRA custodian generally makes a check payable to the financial organization holding the HSA, as custodian or trustee of the HSA. The check is mailed to the HSA custodian for direct deposit into the HSA. The individual does not take possession of the funds.

Example – IRA and HSA at the same financial organization

Mary Jo, age 32, has an IRA and an HSA at ABC Bank. Mary Jo completes an IRA distribution form indicating a qualified HSA funding distribution (or early distribution, no known exception). Mary Jo completes an HSA contribution form identifying the contribution type as a regular contribution. The IRA custodian removes the funds as an early distribution, no known exception from her IRA, and immediately deposits the funds into Mary Jo’s HSA as a regular contribution. Mary Jo will receive an IRS Form 1099-R, reporting the IRA distribution as taxable income. She will also receive a Form 5498-SA, reporting an HSA regular contribution. Mary Jo needs to properly complete her tax return to identify the qualified HSA funding distribution and avoid the tax and penalty tax that would otherwise apply to her IRA distribution.

Example – IRA and HSA at different financial organizations

Using the same example as above, except Mary Jo’s IRA is at ABC Bank and her HSA is at XYZ Credit Union, Mary Jo completes a Request for a Qualified Health Savings Account Funding Distribution form at XYZ Credit Union. XYZ Credit Union sends the request form to ABC Bank. After receiving the request form, ABC Bank makes a check payable to “XYZ Credit Union as Custodian for the Health Savings Account of Mary Jo” and mails it directly to XYZ Credit Union. After receiving the check, XYZ Credit Union will deposit it into Mary Jo’s HSA as a regular contribution. The IRS reporting is the same as in the example above.

Testing period

An individual making a qualified HSA funding distribution requires that he/she remain an eligible individual, covered by an HDHP, during a testing period. The testing period begins with the month the HSA receives the qualified HSA funding distribution and ends the last day of the 12th month following that month. If an HSA owner loses eligibility at any time during the testing period, the IRA distribution amount will be subject to tax and a 10 percent penalty tax in the year the testing period is failed. The penalty is waived if the failure is due to disability, as defined in Internal Revenue Code Section 72(m)(7), or death. The amount is not considered an excess contribution. If any of the amount is withdrawn, the amount is treated the same as any other distribution from an HSA.

Each qualified HSA funding distribution has its own testing period. For example, an HSA owner who has self-only HDHP coverage at the beginning of 2021 contributes the maximum amount on June 20, 2021. Later in 2021, that individual secures family HDHP coverage and due to the increased contribution limit a second qualified HSA funding distribution occurs on August 15. The testing period for the first distribution begins June 2021 and ends on June 30, 2022. The testing period for the second distribution begins August 2021 and ends on August 31, 2022.

Conclusion

The qualified HSA funding distribution provision is an excellent way for an individual to fund an HSA when other funds are not available to make an HSA regular contribution. An HSA owner and the organization(s) acting as the HSA owner’s IRA and HSA custodian need to understand the process to ensure the IRA distribution is reported properly, thereby resulting in a tax-free transfer to an HSA.

For an opportunity to learn more about IRAs and other tax-advantaged accounts including Health Savings Accounts and Coverdell Education Savings Accounts, consider the Wolters Kluwer IRA Library or on-demand video training offered on a variety of topics. Go here to learn more about training opportunities available to you, or you can call us at 1-800-552-9408.
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