The HSA allows for a small but interesting tax loophole for people who have built up savings in an IRA and even a 401(k) account. When you withdraw funds from these tax-deferred retirement accounts those amounts will be taxed at your ordinary income rate in the year withdrawn. However one way to avoid taxes on those assets – or at least a portion of them – is to conduct a tax-free transfer into an HSA account.
You may make a one-time contribution in the form of a direct transfer to your HSA account from your IRA account up to your maximum annual HSA contribution limit. Note that this contribution amount may not be deducted from your income on your tax return.
However you do not have to pay taxes (or penalties) on the IRA distribution as you would if you paid for medical expenses with funds from your IRA. In fact as long as you use the money withdrawn from your HSA for qualified medical expenses you won’t ever have to pay taxes on money transferred from a traditional IRA. The IRA-to-HSA rollover is subject to a 12-month testing period during which time you must remain HSA-eligible. You can also contribute to an HSA from your Roth IRA but since you’ve already paid taxes on Roth assets you wouldn’t benefit from the tax advantage.
You can also use this tactic with a 401(k) plan but you would need to roll over the assets to an IRA first and then conduct the transfer to an HSA subject to your annual contribution limit.
This strategy can be quite valuable if you’re starting to plan for your retirement income. Not only can it supplement a separate savings account designed for health care expenses but also it can reduce the tax liability of invested retirement plan assets.
Premium rates for HDHPs are generally lower than that of other health plans which allows participants to save additional funds to help pay for their health care expenses. Therefore relatively healthy participants who do not have a lot of medical expenses throughout the year can accumulate significant savings over time in an HSA.
In 2014 the HSA contribution limit is $3300 for an individual and $6550 for a family indexed for inflation each year. For those age 55 or older there is a catch-up provision that allows you to kick in another $1000; this limit is not indexed for inflation.
HSA funds may also be used to reimburse the money withheld from Social Security benefits to pay for Medicare Part B pay Part D or Medicare Advantage premiums and pay for a portion of long-term care insurance premiums.
HSA accounts offer the following tax breaks:
- Contributions are not subject to income taxes
- Assets have the potential to grow tax free
- Funds used to pay for qualified medical expenses may be withdrawn tax free
Note that any non-qualified withdrawals made before age 65 will be subject to both income tax and a 20 percent penalty on the amount withdrawn. However once an account owner turns 65 he may use HSA funds for any purpose not just medical expenses – which is why the HSA can be an excellent tax-free vehicle for retirement savings. Bear in mind though that amounts withdrawn after 65 for non-qualified medical expenses will be subject to income taxes – but no other penalties.