New HSA Rules

I remember reading that right around the holidays the President signed a new law that changed some of the rules for health savings accounts and will let people roll over IRA money into an HSA. How do the new rules work?

That new law, the "Tax Relief and Health Care Act of 2006," was signed on December 20, 2006, and did make several improvements to health savings accounts.

As you mention, one of the new rules lets people roll over money from an IRA into an HSA, so they can use the money tax free for medical expenses. But there are a lot of limitations to this new rule.

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You'll be able to make the rollover only once in your life, and the rollover amount is limited to the HSA maximum contribution for the year, minus any contributions you've already made. If you have an individual plan, for example, you can contribute only $2,850 to an HSA in 2007, which would also be the limit on the amount of money you could transfer from an IRA to an HSA. If you've already contributed $1,000 to the HSA this year, then you can roll over only $1,850 from the IRA.

Because you can only make this rollover once in a lifetime, it's good to keep it in mind as an option only in emergencies -- if, for example, it comes down to either making the rollover or going into debt to pay your health-care expenses. And you might have a tough time if you try to do this anytime soon. Regulations have yet to come out, so administrators are still trying to figure out the procedures.

The new tax law did make some other changes to HSAs, however, that will make a bigger difference to everyone. The most important: The maximum HSA contribution is no longer based on the size of your health insurance deductible.

In the past, the contribution maximum was the lesser of your deductible or a dollar limit ($2,850 for individual plans in 2007; $5,650 for families). If you had a family plan with a $2,500 deductible, that was the maximum amount you could contribute for the year. Now, people with family plans can contribute up to $5,650 for the year, regardless of their deductible (as long as they have a deductible of at least $2,200, which they need to qualify for an HSA). Individuals can contribute up to $2,850 but need only a deductible of $1,100 to qualify for an HSA.

Now that people can contribute more than their deductible, they can start to use their HSAs for long-term savings, instead of having to clean out their account if they have a lot of medical expenses. "This has moved this more to the realm of a financial-planning tool, rather than just a health-care tool," says Jerry Ripperger, director of consumer health for Principal Financial Group, which administers HSAs and retirement plans.

The longer you can keep the money in the HSA, the bigger the tax benefits you can reap. You can contribute pre-tax money to the account, where it grows tax deferred and can then be used tax free for medical expenses -- a triple tax benefit that's tough to find anywhere else. The more time the money remains in the account, the greater benefit you'll get from the tax-free earnings.

Ripperger says this change also will encourage more HSA administrators to expand their HSA investing options -- offering more mutual funds for long-term savers rather than just money-market accounts.

The new law also changed the contribution rules for people who enroll in an HSA the middle of the year. In the past, the contribution amount was pro-rated based on when you opened the account -- only allowing the maximum contribution if you enrolled in January. Now, you can make the full contribution -- $2,850 for individual plans, $5,650 for family plans -- no matter when you enroll.

Ripperger says this new rule may be particularly helpful for small-business owners who have a successful year and are looking for ways to lower their taxable income before year-end. "You can move to a high-deductible health plan in the fourth quarter and make the full family contribution to an HSA, which can offset $5,650 in income," he says.

For more information about health savings accounts, see Health Savings Account Answers.