Should You Consider Executing an IRA-to-HSA Rollover?

Federal tax law allows a one-time rollover from an IRA to a Health Savings Account. It's an option worth evaluating.

If you're eligible to fund a Health Savings Account and have a balance in a retirement account, you may be permitted to roll over the retirement-account balance into your Health Savings Account. But not just any retirement account. And the transaction comes with some immediate financial trade-offs and short-term compliance issues. It may not be for everyone. But if you own a Health Savings Account and have a balance in a tax-deferred retirement account, it's worth evaluating this option.

Compliance Issues

You're permitted to make a once-per-lifetime rollover from an IRA to a Health Savings Account. Here are the compliance requirements:

1. You can execute only one rollover in your lifetime. The only exception is if you roll over a balance when you're covered on a self-only policy and later during the same calendar year you move to coverage on a family plan and can roll over more money.

2. The source of rollover funds must be a tax-deferred or Roth IRA. No other form of retirement plan can be used. If you have another plan (including a 401(k) or similar plan at your current or former employer, a SEP IRA, or a SIMPLE IRA) and it's permissible under federal tax law to roll that balance into an IRA, you can take that action, then roll over the balance from the IRA to a Health Savings Account.

3. All funds must come from a single IRA. If you have several small IRAs whose balances you want to roll over into a Health Savings Account, consolidate those balances into a single IRA, then complete the rollover.

4. Once you complete the rollover, you must remain HSA-eligible during a testing period that lasts 12 full months beginning with the first full month after the rollover. If you fail to remain eligible through the end of the testing period, the rollover is treated as a withdrawal from the IRA and may be subject to income taxes and penalties (depending on your age).

Strategies

Is an IRA-to-Health Savings Account rollover the right financial move for you? Consider these factors:

1. You sacrifice an immediate tax benefit. Your rollover amount counts dollar-for-dollar against your maximum contribution for the calendar year. If, for example, you roll over $6,000, that's $6,000 that you can't contribute through pre-tax payroll deductions. At a 22% federal income tax rate, a 5% state income tax rate, and the 7.65% federal pay roll tax, losing the $6,000 contribution means that you lose $2,079 in immediate tax savings.

2. You enjoy long-term tax savings. If you roll over funds from a tax-deferred IRA, you move the money from a taxable to a tax-free distribution stream. All withdrawals from a tax-deferred IRA are included in taxable income. In contrast, all Health Savings Account distributions for qualified expenses are reimbursements, not income, and therefore not included in taxable income.

3. Don't forget to factor in balance growth. At first glance, sacrificing current tax savings for long-term savings may not seem like a good financial move, considering potentially lower income taxes in retirement. For example, at a 12% federal rate and 5% state rate, the tax savings on a $6,000 rollover are only $1,029. But a $6,000 rollover in your 30s or 40s may grow to $20,000 or more annually. Even at $20,000, the tax savings at the 12% and 5% income tax rates are $3,400.

4. Be careful about spending assets. IRAs are far more restrictive than Health Savings Accounts because balances can't be withdrawn (with certain exceptions) before age 59 1/2 without incurring penalties (and, of course, income taxes applied). That restriction gives pause to anyone looking to an IRA as a source of quick cash. In contrast, you can withdraw funds from a Health Savings Account balances for qualified expenses at any age with no tax liability or penalties. But if you roll over $6,000 of retirement assets to a Health Savings Account and then use the funds to pay a medical bill, you've spent $6,000 of long-term assets. That's not a good formula for financial freedom in retirement - unless you commit to and follow through on replenishing that $6,000 to retirement accounts with higher contributions. "Don't eat the seed." Just as farmers have the discipline to retain a portion of this year's harvest for seeds to grow crops next year, you must ensure that you don't spend your long-term assets today.

5. Consider timing. If you want to maximize the amount that you can roll over, be aware of the two situations that increase your annual contribution limits: moving from self-only to family coverage (which increases your contribution limit from $3,850 to $7,750 in 2023) and turning age 55 (which allows you to make a $1,000 catch-up contribution). If your goal is to roll over as much money as possible and you anticipate one of these milestones in the near term, consider delaying action.

6. Assess your future eligibility. Because you must remain eligible throughout the 12-month testing period, take a hard and realistic look at your future eligibility. Do you anticipate layoffs at your company? Are you expecting to enroll in Medicare? Might you move from family to self-only coverage due to divorce, a family member's death, or a child's aging off your plan? Any of these circumstances may make part of or all your rollover subject to taxes and penalties for premature withdrawals from a Health Savings Account.

7. Tax-deferred versus Roth. You can transfer funds from either a tax-deferred or a Roth IRA. When you funded your IRA, your contribution was tax-deductible or pre-tax, just as a Health Savings Account contribution is (although Health Savings Accounts enjoy the additional benefit of being payroll-tax-free). When you execute this rollover, you move your money from a taxable to a tax-free (for qualified expenses) stream. In contrast, Roth accounts are funded with after-tax dollars. Withdrawals are generally not included in taxable income (tax-free). Rolling over funds from a Roth account to a Health Savings Account is generally a bad idea because tax-free distributions are restricted to only qualified expenses, whereas most withdrawals for any expenses from a Roth account are tax-free.

A Bad Reason to Execute a Rollover

Some new Health Savings Account owners see the rollover option as a way to build their account balance quickly and painlessly to pay a current or anticipated expense. The rollover, they conclude, allows them to deposit a lump-sum into the Health Savings Account quickly, without reducing their take-home pay with large payroll deductions. And they're right.

But this action is the perfect illustration of "eating the seed." They'll be left with fewer financial resources to fund their retirement. If they choose the rollover option, a prudent counteraction would be to increase their retirement-savings rate during the next few (but not too many) years to replace dollar-for-dollar the amount that they rolled over and spent. This approach combines the best of both worlds: immediate cash to pay a qualified expense tax-free and replenishing the retirement account with little loss (they won't enjoy growth in their retirement account on the balances withdrawn and not yet replenished). It requires either discipline (keep a mental note of that rolled over balance and not spend it) or a strategy (placing the rollover amount - and other contributions designated for retirement spending - into a second Health Savings Account without easy owner access to funds) to keep long-term savings on track.

But what if you don't have a sufficient balance to pay that early bill? Most providers work with patients to establish a repayment schedule (although this approach doesn't work for prescription drugs, where payment is due at the time of purchase). You can place the funds in your Health Savings Account to enjoy immediate tax benefits, then make your monthly payment from the account.

Some Health Savings Account administrators offer a program that mimics the cash-advance or overdraft-protection feature of a traditional checking account.

And some companies offer payroll loans to help workers who face a sudden expense. They repay those loans through payroll deductions. Health Savings Account owners can contribute to their accounts, then reimburse themselves immediately (as your administrator how) to enjoy tax benefits without sacrificing disposable income.

The Bottom Line

The IRA-to-Health Savings Account transfer is an option worth considering. But be sure to assess your situation accurately to determine whether it's the right move for you - and, if so, when to do so.

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The content of this column is informational only. It is not intended, nor should the reader construe the content, as legal advice. Please consult your personal legal, tax, or financial counsel for information about how this information applies to you or your entity.