In our discussion of Health Savings Accounts (you can see Part 1 here, and Part 2 here), it was mentioned that one possible method for contributing to a HSA is by way of a once-in-a-lifetime tax-free transfer from an IRA. The question is: Does this make sense? When would you want to use this one-time option?
Does This Make Sense?
The reason that the question of sense comes up is because when you are eligible to make contributions to your HSA, you can deduct those contributions from ordinary income. In the case of the tax-free transfer, no deduction is allowed – in fact the income isn’t included at all, so therefore the deduction is lost.
For most folks, the deduction against earned income (above the line; that is, this deduction impacts Adjusted Gross Income and Modified AGI, therefore impacting all sorts of other calculations) is much more valuable than any benefit of a one-time tax-free transfer.
If the IRA is the only source of funds that you have available to make the contribution, you’re probably just as well off to take the distribution, pay the tax, and then take the deduction for the HSA contribution in most cases. This option is available to you every year, not just once in your life. If you are under age 59½ you will owe the 10% early withdrawal penalty in addition to the ordinary income tax, of course.
Other Than Most Cases
So when would it make sense to use this one-time tax-free transfer? I can think of a couple of cases where this might be the right move:
- If you are under age 59½ and you have no other funds available to make a contribution to your HSA, using the rollover/transfer from your IRA would bypass the 10% early withdrawal penalty. I would think you’d want to make this your last resort if you’re in that position.
- If you are in a position where you are eligible to take the distribution from your IRA (you’re over age 59½) but showing the income on your tax return will impact some other external calculation – such as financial aid for college, creditors, state income tax, or an ex-spouse.
The bottom line of all this is: if you have other current income, use those funds to make your deductible HSA contribution. If you have no other source of funds beyond your IRA and you are over age 59½, take the distribution from your IRA as taxable income and then make the HSA contribution from there. As a last resort, if you are under age 59½ and have only your IRA as a source of funds to make a contribution to your HSA – then it might make sense to do the one-time IRA-to-HSA tax-free transfer.
NOTE: It is important to note that this one-time option does not increase the amount that you can contribute to your HSA, nor does it allow you to make a contribution if you are otherwise ineligible to make such a contribution.
If you can think of other situations where the tax-free rollover from your IRA to your HSA might make sense, please leave a comment below!
Photo by Howdy, I'm H. Michael Karshis