Does an IRA-to-HSA Rollover Make Sense? It Depends on Many Factors.

Yes, you can make a one-time rollover from an Individual Retirement Arrangement (IRA) to a Health Savings Account. But should you? Maybe. Maybe not.

The Health Opportunity Patient Empowerment (HOPE) Act of 2006 made a number of positive changes to Health Savings Accounts. It allowed eligible account owners to deposit funds equal to the statutory annual limit, rather than restrict contributions to the lesser of the medical-plan deductible or the statutory limit. It provided a path for people who become HSA-eligible mid-year to make a full, rather than prorated, contribution for that year. And it permitted HSA-eligible individuals to roll over a balance from an Individual Retirement Arrangement to a Health Savings Account.

The Benefits of a Rollover

The rollover provision allows an IRA owner who's HSA-eligible to make the once-per-lifetime rollover at any point. The biggest benefit is that you can roll balances that will be included in taxable income when distributed (balances in a tax-deferred IRA) to a Health Savings Account, from which withdrawals for qualified expenses are tax-free.

For owners with a long time horizon, the benefits are greater than merely reducing taxation on retirement withdrawals. Distributions from a Health Savings Accounts for qualified expenses have three advantages over tax-deferred IRA withdrawals in retirement:

1. IRA owners must begin to withdraw funds in the year that they turn age 72, using a formula from the federal government based on their balance and expected remaining lifespan. These distributions, even if not needed, may bump an owner into a higher tax bracket. In contrast, Health Savings Account owners are never required to withdraw funds from their accounts.
2. High-income seniors pay a surcharge on their Medicare Part B and Part D premiums. Their taxable income is subject to a calculation known as the Income-Related Monthly Adjustment Amount, or IRMAA. For example, a single filer with a taxable income between $91,000 and $114,000 pays a monthly surcharge of $68 ($238.10, versus $170.10) in 2022. That's an additional $816 in annual premium. A bump in taxable income to $114,000 results in a doubling of the monthly premium to $340.20, or an annual increase of more than $2,000.
3. The federal government (and many, but not all, states) taxes Social Security benefits. A single filer whose taxable income exceeds $34,000 finds that 85%, rather than 50%, of her Social Security benefit is included in federal taxable income. For a senior who receives a $25,000 annual Social Security benefit, that's a difference between taxes applied to $12,500 and $21,250 of income. A single filer with $42,000 of income from Social Security, a small pension, and RMDs will pay a 22%, rather than a 12%, marginal tax rate on the last dollars of her income.

The second principal benefit of a rollover is that a Health Savings Account owner can, in effect, make a premature withdrawal from her IRA to pay a current medical expense without incurring taxes or penalties if she first rolls the money from the IRA into her Health Savings Account. This move can save $1,000 or more in immediate taxes and penalties.

The Rules of a Rollover

You must follow specific rules to complete the transaction without incurring taxes or penalties:

1. The funds must come from a single IRA, not multiple IRAs or other retirement accounts. You may be able to roll balances from another type of retirement account into an IRA or consolidate multiple IRAs into a single account to execute the rollover.
2. There is a once-per-lifetime limit on rollovers. You can't move funds every year to enjoy additional tax benefits. The only exception is if you complete a rollover when enrolled in self-only coverage and later that calendar year switch to family coverage. In that one case, you can roll over additional funds.
3. The rollover is included in your contribution limit in the year of the transfer. It may make sense for some owners to wait until a life change - moving from self-only to family coverage, or turning age 55 and being allowed to contribute another $1,000 annually - to execute the rollover to maximize the amount that can be moved.
4. You must remain HSA-eligible through the testing period, a span defined as 12 full months after the month that the rollover is completed. If you fail to remain eligible during the testing period, the full amount of the rollover is included in your taxable income. If you're under age 65 and not disabled, you pay a 20% additional tax as a penalty.

You can roll over funds from either a tax-deferred or Roth IRA. Your better bet financially is the tax-deferred IRA because you received the tax deduction on the contribution and must pay taxes on your (presumably higher) balances as you make voluntary or required minimum withdrawals. Rolling those funds to a Health Savings Account allows you to withdraw balances tax-free for qualified medical expenses. And you'll have plenty later in life, including Medicare premiums, Medicare cost-sharing, and dental and vision expenses.

On the other hand, you paid taxes on Roth contributions when you deposited the funds. You took the tax hit up front because withdrawals are almost always tax-free, regardless of your use of funds. Why move those balances to a Health Savings Account, which offers tax-free distributions for only qualified health-related expenses?

Is It a Good Idea to Complete a Rollover?

This is a question that must be answered individually, based on your circumstances. Here are two considerations:

You want to move a retirement asset to avoid future taxes. This is the textbook-definition of the right reason to execute a rollover. You avoided federal and state income taxes (but not federal payroll levies) on your contributions. If you retain the money in your IRA, withdrawals - even for qualified medical expenses - will be included in your taxable income. In contrast, when the money is placed in the Health Savings Account, you can make distributions for qualified expenses with no tax liability.

You want to pay a current medical bill. The benefit here is much less clear. Many premature withdrawals from retirement accounts are used to pay for medical services. If you're committed to using retirement assets to pay current medical expenses, then the rollover provides a clear benefit (no income taxes or penalties on the distribution). But you sacrifice a long-term asset to pay an immediate expense. It may be better to negotiate repayment terms, sell an asset, secure a loan, or pick up a second job to pay the medical bill. You can always reimburse yourself from future tax-free contributions to your Health Savings Account.

The Third Consideration

Finally, consider what you sacrifice by completing the rollover. Let's say you want to roll over $6,000 from your tax-deferred IRA to your Health Savings Account. Every rollover dollar is a dollar that you can't contribute through pre-tax payroll deductions or tax-deductible contributions of personal funds. Thus, your taxable income will be $6,000 higher, yet your total assets (retirement and Health Savings Account) won't change.

Here's an alternative to consider: Forego the rollover. Contribute the extra $6,000 to your Health Savings Account through your company's Cafeteria Plan and save on federal income and payroll taxes and state income taxes (unless you reside in California or New Jersey, the two states that don't allow a state income tax deduction). You'll probably save between $1,500 and $2,000 in taxes, including more than $450 in payroll taxes (assuming your income is less than $147,000 in 2022 - the payroll-tax savings are less at higher income levels).

Then, convert $6,000 of your tax-deferred IRA balance to a Roth IRA. You'll pay taxes on the conversion. The conversion will increase your taxable income by $6,000, the same amount by which your Health Savings Account contributions reduce your taxable income. So, this transaction is a wash on federal and state taxes. But you save an additional $450 in payroll taxes when you fund your Health Savings Account and don't complete the rollover. Thus, you come out ahead by pursuing the Roth conversion.

(Note: California and New Jersey residents need to think differently, as the lack of a state tax deduction for Health Savings Account contributions may make the rollover a more attractive option.)

The Bottom Line

The once-per-lifetime opportunity to roll over a portion of IRA balances to a Health Savings Account gives you more flexibility in managing your personal finances. But you must weigh the benefits and drawbacks before acting. You may benefit financially by keeping your IRA balance intact (perhaps with a tax-deferred-to-Roth conversion, as outlined above) and funding your Health Savings Account more aggressively.

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