Is it time to shift from an IRA to an HSA? What you should know about IRA-HSA distributions
Your health savings account, or HSA, is a smart way to pay for medical expenses because of your accounts' tax breaks. But with relatively small contribution limits, it may take time to grow. There is a lesser-known strategy you can use to boost your balance, though: an IRA-to-HSA-rollover. Here's what to know and how to decide if it's right for you.
Individual retirement account (IRA) basics
An individual retirement account, or IRA, offers tax incentives to save for retirement. These may include upfront tax deductions or tax-free growth. You can contribute up to $6,000 per year ($7,000 if you're 50 or older), but you can't deposit more than you earned for the year.
- Traditional IRA - You can contribute pre-tax money, and you may be able to deduct those contributions. The funds grow tax-deferred until you're ready to spend the money in retirement. There may be deduction limits if you have a workplace retirement plan. You can see these limits here and here.
- Roth IRA - You can contribute after-tax money, the funds may grow tax-free, and after meeting specific rules, you can use the money tax-free in retirement. You can see the income limits for Roth IRA contributions here.
- Rollover IRA - You may also have a rollover IRA, which is money rolled over from your workplace 401(k), 403(b), or another retirement plan.
Health savings account (HSA) basics
Your health savings account (HSA) is another tax-savvy plan that can make healthcare more affordable. To qualify, you must have an eligible high-deductible health plan through your employer or on your own.
Your HSA offers more options than your flexible spending account (FSA) because there is no deadline to use the money, and if you change jobs, you can take your HSA with you. Your HSA offers three tax benefits, making it one of the most tax-friendly accounts.
- Tax-deductible contributions - You can contribute money before taxes or take a deduction for your contributions. This perk is available even if you don't itemize deductions on your tax return.
- Tax-free growth - If your HSA offers a way to invest the money, you can grow the balance without paying taxes on your earnings.
- Tax-free withdrawals - When you are ready to spend the money, you can make tax-free withdrawals, as long as you use it for qualified medical expenses.
IRA-to-HSA rollover rules
Your HSA may offer more tax benefits than your IRA, so if you want to complete an IRA-to-HSA rollover, there are some specific rules to follow. Consider these guidelines before moving your funds.
1. You must have an eligible health insurance plan
To qualify for an IRA-to-HSA rollover, you must have an eligible high-deductible health insurance plan. For 2021, your individual health plan must have a deductible of $1,400 or more, and family plans must have a deductible of at least $2,800. The out-of-pocket costs can't be more than $7,000 for individual coverage or $14,000 for families, and you need to stay eligible for at least twelve months after the rollover.
2. You can't transfer more than your annual limit
Another rule to know: There is a limit on how much you can transfer through an IRA-to-HSA rollover. You can't move more money than your annual HSA contribution limit. For 2021, you can contribute $3,600 as an individual and $7,200 for a family plan, and if you already added money in 2021, you will have to reduce your IRA-to-HSA rollover by that amount.
3. You need to make a trustee-to-trustee transfer
When completing an IRA rollover, it's critical to keep track of the 60-day rule. After making a withdrawal, you have 60 days to deposit money into the new account. If you don't, the IRS considers it a retirement plan distribution, and you could owe income taxes or penalties.
Your IRA-to-HSA rollover must be a trustee-to-trustee transfer, which means the money moves directly from one plan to another. By completing this type of transfer, you can avoid taxes or penalties on the withdrawal.
4. You must have the right type of IRA
If you want to try an IRA-to-HSA rollover, you may be tallying up each of your IRAs. But unfortunately, not all IRAs will qualify for the rollover. The IRS says you can complete an IRA-to-HSA rollover with a traditional IRA or Roth IRA only. Your workplace SEP IRA or SIMPLE IRA won't qualify.
5. There is no tax deduction for the rollover
One of the perks of HSA contributions is the tax deduction, which lowers your taxable income. You can deduct your contributions "above-the-line" on your tax return, meaning you can take the deduction whether you itemize tax deductions or not. But unfortunately, your IRA-to-HSA rollover won't get the same tax treatment.
6. You can only do it once in a lifetime
If you want to make an HSA-to-IRA rollover, you will need to make sure it's the right move. Here's why: the IRS only allows you to do it once per lifetime. Before using your one-time transfer opportunity, you may want to explore other HSA funding options.
The benefits of an IRA-to-HSA rollover
An IRA-to-HSA-rollover could make sense if your family's budget is tight and you are expecting a significant medical expense soon. It may be better to choose a traditional IRA vs. a Roth IRA because you would pay taxes on those withdrawals.
For example, let's say you or your spouse is overdue for surgery, and you still haven't met your family's health plan deductible. While your insurance company may reduce the bill, you could be on the hook for a large chunk of out-of-pocket expenses.
If you can't afford to pay the out-of-pocket costs, an IRA-to-HSA rollover could offer access to tax-free funds, which you may prefer over accruing debt. But, of course, there are tradeoffs to consider before making this move.
The risks of an IRA-to-HSA rollover
If you're moving money from your IRA to your HSA, chances are you may need the funds for a medical expense. While it may be better than an early retirement plan withdrawal, you should consider the downsides of using retirement money.
By tapping your IRA early, that money won't have the chance to grow over time, which could mean a smaller nest egg. If you want to know the opportunity cost, you can plug your withdrawal into a compound interest calculator and see how much money you could have by leaving your IRA funds. Ultimately, there is no right or wrong decision; you will have to choose the best option for your family.
Should you complete an IRA-to-HSA rollover?
When it comes to personal finance, most advice isn't one-size-fits-all, and an IRA-to-HSA rollover is no exception. Before making a choice you can't reverse, it's critical to weigh the pros and cons and how each one may impact your finances. If it feels like too much to navigate on your own, you could seek guidance from a tax professional or financial advisor.
Although it may be tough with limited income, you may try other funding options, like deferring more money into your HSA from every paycheck. Even $25 more could make a difference over time. You could also make tax-deductible contributions from unexpected windfalls, like your tax refund.
Kate DoreKate Dore is a Nashville-based personal finance writer and Candidate for Certified Financial Planner™ Certification. She teaches financial literacy with Junior Achievement and writes for Lifehacker, Business Insider, Investopedia, and Credit Karma. You can follow her on Twitter at @KateDore.