Tag Archives: Testing Period

Not Using the Last Month Rule when Coverage Changes

This question was submitted by HSAedge reader Kevin. Feel free to submit your question today to evan@hsaedge.com.

I have an additional question/scenario regarding the Last Month Rule I was hoping you could help with. My wife and I began a HSA-eligible policy August 1 of this year. On January 1, we will switch to an Obamacare plan that is not HSA eligible. I assume that we would NOT be eligible to make HSA contributions in 2017 under this plan. If so, does that mean we are ALSO not able to make contributions in 2016 (without failing testing period and paying penalty)?

If I understand you correctly, you have HSA eligible coverage from Aug through Dec of 2016. On January 1st 2017 you are switching to a new plan that is HSA eligible but ACA modifications make it de facto HSA ineligible.

If that is true, you can definitely still contribute to your HSA for 2016 but on a pro rata basis, i.e. proportionate for the months you had coverage. By my count that is 5/12 months so your 2016 contribution limits would be:

Single coverage = 5/12 * $3,350 = $1,395.83
Family coverage = 5/12 * $6,750 = $2,812.50
If you are 55 or older add 5/12 * $1,000 = $416.67 to above amounts

The key point is that you can always contribute to your HSA for times that you had HSA eligible coverage, full stop. You then have the decision of whether to use the Last Month Rule or not, so it is optional. Using it allows you to contribute the full year’s HSA contribution limit (e.g. $3,350 or $6,750 above) regardless of actual time covered. Not using it -and this is what trips people up- reverts to the default, which is a contribution limit determined by the number of months coverage. No one is forced into using the Last Month Rule, and doing so can be detrimental, since as you note the Testing Period comes into play along with the risk of penalty.

So in your situation, with an upcoming coverage change that would fail the Testing Period, it is definitely best to avoid using the Last Month Rule.

Qualified HSA Funding Distributions – Contribute to your HSA from your IRA

Note: if you are struggling with the Qualified HSA Funding Distribution on Form 8889, please consider using my service EasyForm8889.com. It asks simple questions and will complete Form 8889 for you faster than you can read this article.

Fund your HSA with your IRA

Besides all of the other benefits of HSA’s, the folks at the IRS have included a provision that allows you to fund your Health Savings Account from your traditional IRA or Roth IRA. This is called a Qualified HSA Funding Distribution and it allows you to contribute your yearly HSA contribution limit from your IRA. The IRS limits this activity to occur once in your lifetime but you will see that, in fact, you can make up to two qualified funding distributions in your lifetime. Additionally, there are some restrictions on how you make the transfer and that you maintain coverage after the transfer (called the Testing Period). We will give you the details and help you avoid taxes and penalties when making an HSA contribution from your IRA.

What types of IRA’s are allowed for Qualified Funding Distributions?

First of all, you have to have an individual retirement account (IRA) with some funds in it to contribute to your HSA. The IRS stipulates that your IRA be a traditional IRA or Roth IRA. They do not allow that an “ongoing” IRA be used for Qualified Funding Distributions, so this excludes ongoing SEP IRA’s (generally self employed) or SIMPLE IRA’s (cousin of the 401(k)). The IRS considers “ongoing” IRA’s to be those where an employer has made a contribution within the tax year that the HSA funding distribution would occur. Whether your plan is “ongoing” or “inactive”, and if you can contribute, is beyond the scope of this discussion but may be worth researching.

How much can I contribute to my HSA from my IRA?

The amount that you can contribute from your IRA to your HSA depends on your HSA coverage, your age, and the tax year. The quick rule is you can only contribute up to your maximum HSA contribution limit for the tax year in question. This isn’t a way to get extra money into your HSA, just a way you can fund it from an established source. So for 2017 here are some examples for the maximum contribution from your IRA to Health Savings Account:

Your insurance	HSA Contribution Limit (2017)	Qualified Funding Distribution Limit (2017)
Self Only	$3,400	$3,400
Self Only, 55+	$4,400	$4,400
Family	$6,750	$6,750
Family, 55+	$7,750	$7,750

Note that this amount is determined using 1) the HDHP coverage you have at the beginning of the month that the Qualified HSA Funding Distribution occurs, and 2) the your age at the end of the tax year.

When can I make a Qualified HSA Funding Distribution?

The IRS has ruled that you may transfer from your IRA/Roth IRA to your HSA once during your lifetime. This isn’t once per year, this is one and done. So if you are going to contribute from your individual retirement account, make it count. Use this information to plan and don’t make the mistake of funding too little, because you won’t get another chance.

However, like all good rules, there is one exception. If you make a Qualified HSA Funding Distribution while on Self-Only coverage, you may make an additional Qualified HSA Funding Distribution during the same year if your coverage changes to Family. This allows you to “step up” your contribution amount and in theory rollover a considerably higher amount of money from your IRA. And when you add the 55+ additional catch up contribution, this can be large. If you are over 55, this amount goes from $4,400 to $7,750, a significant increase. However, the IRS is explicit that this must happen in the same year, so it would require a significant event / lack of planning to occur, but hopefully it is useful for someone.

How to actually make the HSA contribution + tax effects

The IRS requires that any qualified funding distribution be made in a trustee to trustee transfer. This means that your IRA trustee (bank) must transfer the money directly to your HSA trustee (bank), without sending you a check. This prevents the money from going “missing” or being spent on non qualified medical expenses. It also prevents any time delays where the money is out of the system. Thus, to actually make the contribution you will have to log in to (or visit) your IRA bank and setup your HSA bank as a related account. You will then need to transfer the money directly to the HSA account, not to yourself. If the option is given, categorize each transaction (both the out and in) as an HSA Qualified Funding Distribution with your bank. This will allow you to remember exactly what happened and potentially avoid IRS warning signs on un-taxed IRA distributions / excessive HSA contributions. Either way, this amount will be indicated as a qualified funding distribution when you file Form 8889 that year.

If done properly, a qualified funding distribution is not included in your income, not tax deductible, and reduces the amount you can contribute to your HSA. This makes sense since because, in order, 1) you don’t need to pay taxes on this money, 2) you already took the tax deduction so you can’t double dip, and 3) it is an HSA contribution so you are prevented from contributing excess.

All in all these are pretty reasonable requirements and provide great flexibility to move money from an IRA to your HSA. However…

The Testing Period

HSA Funding Distributions have a Testing Period that requires that you maintain coverage after making the contributions. For those of you familiar with the Last Month Rule and its Testing Period, the concept is similar. If you make a Qualified Funding Distribution to your HSA you must maintain HSA eligible insurance for just over 1 year after the distribution is made. The IRS defines the Testing Period in Publication 969 (PDF) as:

The testing period begins with the month in which the qualified HSA funding distribution is contributed and ends on the last day of the 12th month following that month.

So the Testing Period lasts for twelve months but through the end of that 12th month of the following year. As an example, if you make a qualified HSA funding distribution on April 1st of 2017, you must maintain HSA eligible coverage through April 30th, 2018. If you make more than one Qualified Funding Distribution by means of different coverage (self-only vs family), each distribution has its own Testing Period.

Failing the Testing Period

Unfortunately, the IRS levies hefty taxes and penalties if you fail the aforementioned Testing Period during the subsequent 12 calendar months. If for any reason you are no longer an eligible individual during that time, your previous Qualified Funding Distribution is:

Included in income (taxed)
Assessed a 10% penalty

So very stiff taxes and penalties for failing the Testing Period. Your previously tax free IRA contribution becomes taxed and, to top it off, a 10% penalty is levied. Again, per IRS Publication 969, the penalty for violating the Qualified Funding Distribution Testing Period is:

If you fail to remain an eligible individual during the testing period, other than because of death or becoming disabled, you will have to include in income the qualified HSA funding distribution. You include this amount in income in the year in which you fail to be an eligible individual. This amount is also subject to a 10% additional tax.

This is a bit onerous of a restriction and one that is not to be taken lightly, as it carries quite a significant penalty. The key metric for determining failure is failure to remain an eligible individual. This means that you:

1) You must be covered under a high deductible health plan (HDHP) on the first day of the month
2) You have no other health coverage (see exceptions), you are not enrolled in Medicare, you cannot be claimed as a dependent

Thus, if you are thinking about changing insurance, thinking about a job change, or have a reasonable chance of losing your current health insurance, you will want to carefully consider taking the risk of making the Funding Distribution. In the following section you will see how to report this amount on HSA Form 8889 as well as how to account for taxes and penalties owed from

How to contribute to an HSA from a 401(k)

Notice that there has not been much talk about funding your HSA from your 401(k). This is because a 401(k) is an employer controlled plan and considered “ongoing” by the IRS. Thus, you cannot contribute directly to your HSA from a 401(k). But, there is an easy way to get around this, which is first converting your 401(k) into an IRA. Once that occurs, the account is out of your employer’s control and you are free to make the Qualified HSA Funding Distribution. You will want to be careful to do this by the book and avoid any taxes, but this should be easy enough to do to get funds from your 401(k) into your Health Savings Account.

Qualified HSA Funding Distributions on Form 8889

You will see the words “Qualified HSA Funding Distribution” in two places on HSA tax Form 8889. The first occurs on line 10 and records current year funding distributions made from your IRA. This is the most frequently used line and will reduce the amount you can contribute to your HSA for the year:

easyform8889-com_qualified_hsa_funding_distribution

The second instance of “Qualified HSA Funding Distribution” occurs on Line 19. For most people, this will be $0. However, for those that previously contributed to their HSA from their IRA and failed the Testing Period, they will need to make an entry here that is equal to the entire amount of their HSA Funding Distribution. This amount will be flow through to Line 20 where it is taxed and Line 21 where it is penalized:

easyform8889-com_qualified_hsa_funding_distribution_penalty

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Note: if you have an HSA, please consider using my service EasyForm8889.com to complete Form 8889. It is fast and painless, no matter how complicated your HSA situation.

Can I use the Last Month Rule for my first year on HSA?

This question was submitted by HSA reader Jennifer. Send yours in to evan@hsaedge.com

In 2015 I had health coverage under my spouse’s PPO. We divorced and I went on the Health Exchange effective July 1. I also opened a HDHP and an HSA account effective July 1, 2015. I contributed the full family amount of $6650 because my kids are on it too.

It was my understanding that as long as I was an eligible individual on December 1, 2015, I could deduct the full $6650 on my 2015 return. According to the Last Month Rule, I thought I would have a testing period for the next 12 months (and I do plan on staying on this same plan with HSA). My accountant is saying I have to prorate for 6 months, and I can only deduct $3325. Is he correct? If he is, I don’t understand the point of the Last Month Rule.

Thanks for your email, you are exactly correct in your interpretation of the Last Month Rule. For reference, here is a detailed article about the HSA Last Month Rule / Testing Period.

Your accountant is correct that the general theme of calculating Line 3 (contribution amount) is pro rata across months. See this post on Determining your Contribution Limit. However, like you said, there is an exception which is the Last Month Rule and your situation appears to fully warrant its use. Per Form 8889 Instructions:

Last Month Rule: if you are an eligible individual on the first day of the last month of your tax year (December 1 for most taxpayers), you are considered to be an eligible individual for the entire year.

Thus, as long as you have health insurance on December 1st, you can contribute up to the full amount for that year’s contribution limit, based on the type of insurance you had on December 1st (Family / Single).

But as Jennifer astutely pointed out, she has to maintain compliance with the Testing Period. Again, back to Form 8889 Instructions:

Testing Period: you must remain an eligible individual during the testing period. The testing period begins with the last month of your tax year and ends on the last day of the 12th month following that month (for example, December 1, 2015 – December 31, 2016). If you fail to remain an eligible individual during this period, other than because of death or becoming disabled, you will have to include in income the total contributions made that would not have been made except for the last-month rule. You include this amount in income in the year in which you fail to be an eligible individual. This amount is also subject to a 10% additional tax.

Thus, if you take advantage of the HSA’s Last Month Rule, make sure you plan on maintaining HSA eligible health insurance for the following year. Otherwise, the next year you will face a penalty in Part III of Form 8889 for 10%, plus owe taxes on that amount.