The QHFD- What, Who, How and Why

We have lauded the benefits of Health Savings Accounts (HSAs) many times in past blogs. They can boost your retirement savings and be a great resource to cover medical expenses in retirement. In fact, a recent article in Forbes touts these savings vehicles as perhaps the best retirement planning tool available.

A recap of the benefits of an HSA:

Contributions to HSAs are tax deductible. The annual contribution limit for 2019 is $3500 for individual coverage and $7000 for family coverage.
Any income and/or gains grow tax free in the account.
Distributions are tax free when used to pay for qualified medical expenses. If you withdraw money from your HSA for something other than qualified medical expenses before you turn 65, you will have to pay income tax at your regular income tax rate plus a 20% penalty. After you turn 65, the 20% penalty no longer applies.

One little-known fact about HSAs is that HSA rules allow you to do what is called a Qualified HSA Funding Distribution, also referred to as a QHFD. This rule allows you to make a one-time transfer of funds from an individual retirement account (IRA) to your HSA. The QHFD is a once in a lifetime only transfer. Under the QHFD rules, this transfer, combined with any other contributions to the account during the year, cannot exceed the year’s HSA contribution limit.

You might wonder why someone would want to take money out of a tax-deferred IRA and move it to an HSA. After all, there is no income tax deduction when you transfer funds from an IRA to a QHFD, as there is in a normal HSA contribution. Yet, in certain circumstances, a transfer from your IRA might be a good financial planning move.

Someone in these two scenarios might benefit from a Qualified HSA Funding Distribution:

If you need cash to fund your HSA contribution for the year. If you do not otherwise have cash available for other sources in any given year that you would like to fund your HSA, this is a potential source.
If your tax-deferred bucket of money is heavy and your Roth bucket is light. Meaning if you have a lot of funds in an IRA, but not as much as you might like in a Roth IRA. This essentially offers the same benefit as a Roth conversion, converting pre-taxed funds to taxed funds. However, in the case of the QHFD, you don’t have to pay the tax bill on the distribution. It’s a tax-free conversion.

A few other items that are important to know about a Qualified HSA Funding Distribution:

Not subject to the Pro-Rata Rule.

A QHFD can come from a traditional IRA, Roth IRA, an inactive SEP or Simple IRA. However, Roth IRA transfers are limited to accumulated investment income, and since only pre-tax money can be transferred, there is not much benefit here. A QHFD distribution is not subject to the pro-rata rule. So, if you have a comingled IRA, meaning pre and after-tax money in the same IRA, and you do a QHFD, you can move the pre-taxed funds out of the IRA and leave the after-tax funds in the account. Again, you are only permitted to move pre-tax funds.

This counts as your RMD.

A QHFD counts toward your RMD for the year.

Only transfers, no rollovers.

A qualified HSA funding distribution must be moved as a trustee- to- trustee transfer. You cannot do a 60- day rollover. The IRA and HSA must be owned by the same individual.

Combine multiple IRAs first.

As mentioned above, you are allowed one QHFD in your lifetime. If you happen to have multiple IRAs, you can only do one QHFD from one account. If you have smaller balances in multiple IRAs, you must first combine the IRAs, then proceed with your one-time QHFD.

Coverage change exception.

The only exception to the once-in-a-lifetime rule is if you have self-only coverage on the first day of the month in which you do a QHFD, but later switch to family coverage in that particular year. You are permitted to do an additional QHFD to complete the remaining difference between the self only contribution limit and the family contribution limit.

Lastly, there is one important thing to note. A QHFD does become taxable if you end up no longer qualifying for an HSA during the time frame beginning on the first day of the month when the QHFD is made and ending on the last day of the 12^th month following that month. For example, if you make a QHFD on February 9, 2019, you must remain eligible for an HSA from February 1, 2019 through February 28, 2020. There is an exception if you are no longer eligible due to death or disability. So, if you intend to take advantage of a Qualified HSA Funding Distribution, make sure your likelihood of being eligible for an HSA for twelve months is very high.