A tax law enacted a little over a year ago—the Tax Relief and Health Care Act of 2006—included several key improvements for HSAs.
Strategy: When it makes sense, roll over funds from an IRA to an HSA. The transfer is tax-free. Then you can take tax-free distributions from the HSA to pay for qualified medical expenses. This special tax break (i.e., tax-free distributions to pay medical expenses) is only available to HSA owners. IRA distributions for medical expenses are taxable. But there’s a catch: You can only do this once in your lifetime.
Similar rules apply to rollovers from a flexible spending account (FSA) or health reimbursement arrangement (HRA).
Here’s the drill: Normally, a distribution from an IRA is subject to tax at ordinary income rates. But the 2006 law allows you to transfer IRA funds to an HSA—just once—completely tax-free. Moreover, the usual 10% penalty on preage 59 1/2 withdrawals doesn’t apply. You can’t roll over more than the maximum HSA contribution for the year. For 2008, the contribution cap is $2,900 for an individual; $5,800 for family coverage. Anyone overage 55 can chip in an extra $900.
Tip: Once the rollover election is made, it’s irrevocable. There’s no going back!