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How is rollover of a Medical Savings Account (MSA) into an HSA treated by the federal government for tax purposes? Funds from an "Archer MSA" may be rolled-over into an HSA within 60 days of withdrawing the funds from the MSA. There are 2 different types of rollovers and the differences are critical in terms of tax implications: 1) Trustee-to-Trustee: this involves a direct transfer of funds from the old MSA trustee to the new HSA trustee, and there is no money or checks that the individual receives directly. This is technically not a rollover, because a rollover means that the funds were first distributed to the individual participant. This trustee-to-trustee method does not trigger a taxable event since the participant never touches the money. Trustee-to-trustee transfers are not subject to any tax withholding and are exempt from the one per 60 day rollover rule. 2) Actual Rollover: a rollover occurs when the trustee distributes the MSA assets directly to the individual participant (the participant receives the check). In this case, the individual must transfer the assets to the new trustee within calendar 60 days after the receipt of the distribution. An IRS reporting requirement and potential tax penalties are imposed if the person misses the 60 day deadline. In general, individuals are allowed one MSA to HSA rollover per 12 month period. In addition, asset rolled-over during the previous 12 months (e.g. MSA to MSA) are not eligible for rollover. If a rollover is made from the MSA that does not meet the criteria described above, the action will be considered a non-qualified distribution that should be included in the account beneficiary's gross income and also subject to an additional 10% tax. Tax treatment of MSA to HSA rollovers can vary at the state level. The federal government does not tax MSA to HSA rollovers as long as the rollover meets the criteria described in item 5 above. Therefore, states that have harmonized their tax treatment of HSAs with the federal government will also allow tax-free rollovers. In states that have not harmonized HSA tax treatment with the federal government, MSA to HSA rollovers would be considered a non-qualified distribution. The rollover funds would therefore be subject to state income tax plus a 10% penalty. If I live in a state that has not harmonized its HSA tax treatment with the federal government, then what are my record-keeping overheads to do my federal and state taxes correctly? In this situation, the individual has significant record-keeping responsibilities. Record-keeping requirements would pertain to HSA contributions as well as the account's earnings as the earnings would be subject to state income tax. Qualified distributions would be tax-free since fund contributions have already been taxed at the state level. Tracking the income (e.g. interest, dividends, realized capital gains) that an account holder should report on a state tax return could prove challenging and is significantly affected by the reporting capabilities of the given financial institution. Generally, the HSA owner needs to keep a permanent record of: a) the deduction taken at the federal level for the HSA contribution; b) the amount of income generated during the course of a given year, and; c) the amount of income that has been reported each year for state income tax purposes. If you rollover an MSA into an HSA in a state like California, those rollover funds would be considered a "non-qualified distribution" and would be subject to state income tax as well as the 10% penalty.
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