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CCH® PENSION AND BENEFITS — 6/20/08

IRS issues guidance on treatment of qualified HSA funding distributions

The IRS has issued a notice providing guidance on the proper tax treatment of qualified health savings account (HSA) funding distributions, effective for tax years beginning after 2006. A qualified HSA funding distribution is a one-time, direct transfer from an individual’s traditional individual retirement account (IRA) or Roth IRA to the individual’s HSA. In general, such distributions are excluded from gross income and are not subject to the 10-percent early distribution penalty under Code Sec. 72(t) .

The IRS guidance reflects the rules provided in Code Sec. 408(d)(9) , as added by the Tax Relief and Health Care Act of 2006 (P.L. 109-432), and includes numerous examples that illustrate how these rules should be applied. Among the Code Sec. 408(d)(9) rules discussed in the guidance are the tax treatment of qualified HSA funding distributions, the restrictions on the types of IRAs from which distributions can be made, the maximum amount of distributions, the number of distributions that are allowed, the procedures for making an IRA-to-HSA transfer, and the testing period rules.

Tax treatment of qualified HSA funding distributions

The notice explains that a qualified HSA funding distribution from an individual’s IRA or Roth IRA to that individual’s HSA is not included in gross income if the individual is an eligible individual under Code Sec. 223(c)(1) . Moreover, notwithstanding the pro-rata basis recovery rules under Code Sec. 72 , for purposes of determining the basis in any amount remaining in an IRA or Roth IRA following a qualified HSA funding distribution, the qualified HSA funding distribution is treated as included in gross income to the extent that such amount does not exceed the aggregate amount that would have been so included if there were a total distribution from the IRA or Roth IRA owner’s accounts. For example, if an individual who has $200 of basis in an IRA with a fair market value of $2,000 makes a qualified HSA funding distribution of $1,500 from the IRA, then immediately after the distribution, the individual retains $200 of basis in an IRA that has a fair market value of $500.

If a qualified HSA funding distribution from an individual’s IRA or Roth IRA exceeds the aggregate amount that would have been included in gross income if there were a total distribution from that individual’s IRA or Roth IRA accounts, the individual’s basis in the excess amount (i.e., the amount that would have been excluded from gross income in a distribution to which Code Sec. 408(d)(9) did not apply) does not carry over to the HSA.

The notice also explains that the amount contributed to the HSA through a qualified HSA funding distribution is not allowed as a deduction and counts against the individual’s maximum annual HSA contribution for the taxable year of the distribution. In addition, the taxability of these distributions is subject to the testing period rules in Code Sec. 408(d)(9)(D).

Limitations on qualified HSA funding distributions

A qualified HSA funding distribution may be made from a traditional IRA under Code Sec. 408 or a Roth IRA under Code Sec. 408A , but not from an ongoing SIMPLE IRA or an ongoing SEP-IRA. For this purpose, a SEP-IRA or SIMPLE IRA is treated as ongoing if an employer contribution is made for the plan year ending with or within the IRA owner’s taxable year in which the qualified HSA funding distribution would be made.

Furthermore, the guidance indicates that if an individual owns two or more IRAs and wants to use amounts in multiple IRAs to make a qualified HSA funding distribution, the individual must first make an IRA-to-IRA transfer of the amounts to be distributed into a single IRA, and then make the one-time qualified HSA funding distribution from that IRA.

The guidance explains that a qualified HSA funding distribution from the IRA or Roth IRA of an eligible individual to that individual’s HSA must be less than or equal to the IRA or Roth IRA account owner’s maximum annual HSA contribution. The maximum annual HSA contribution is based on the individual’s:

1. age as of the end of the taxable year and
2. type of high deductible health plan (HDHP) coverage (self-only or family) at the time of the distribution.