“The good news is that the federal government is running a well advertised sale on federal income taxes. . . . Thus, a rollover now will cost you less than it would before 2018, since marginal tax rates are lower.”
William G. (Bill) Stuart
Director of Strategy and Compliance
April 18, 2019
Most Americans don’t understand that they have a (or another) partner in retirement: Uncle Sam. He’s entitled to a portion of every dollar that you withdraw from most retirement accounts. In fact, he has some tools to force you to make withdrawals so that he can take his cut of funds on which you received a tax break when you contributed them.
You can fight back. And a good financial planner or retirement advisor can tell you how. One of the weapons at our disposal is a Health Savings Account. But you need to understand the rules, because chances are our advisor hasn’t read my new book, HSAs: The Tax-Perfect Retirement Account (available through the publisher here and for pre-order at Amazon here).
Your best weapon may be to open an HSA, contribute to the maximum (funding some of your contribution with funds that you’d otherwise direct to your employer-sponsored retirement plan after you’ve secured the full employer match), and enjoy immediate tax savings (no federal or state income taxes and no federal payroll taxes on HSA contributions) as well as tax-free earnings on investments and tax-free distributions when you withdraw funds for qualified expenses.
Another approach, used much frequently but very effective when deployed properly, is a rollover from an Individual Retirement Arrangement (IRA) to an HSA. Let’s explore how you can take advantage of this opportunity and assess the financial opportunity and potential risks.
You can make a one-time rollover from an Individual Retirement Arrangement (IRA) to an HSA. The total rollover is limited to your maximum contribution for the year that you roll over the funds. In 2019, the statutory maximum annual contribution is $3500 for self-only coverage and $7,000 for family coverage – plus an additional $1,000 if you’re age 55 or older.
If you’re looking for a huge tax shelter, this isn’t it. But if you want to move some money from one type of retirement account to another, an IRA-to-HSA rollover is a viable option.
Here’s why you should consider this opportunity: When you contributed funds to your traditional (non-Roth) IRA, you received a dollar-for-dollar reduction in taxable income at both the federal and state levels (if your state assesses an income tax). You were assessed payroll taxes when you earned the money, and you can’t receive a credit for that amount (7.65% of all income below a threshold – $132,900 in 2019).
When you withdraw those funds in retirement, the distributions are included in your taxable income. You pay federal and state (if applicable) taxes on every distribution from a traditional 401(k), regardless of the items that you purchase with the funds.
You can avoid this tax liability by rolling over a portion of your traditional IRA funds to an HSA. The tax treatment of HSA distributions in retirement is much more favorable: You pay no federal or state income taxes for any withdrawals for qualified expenses. And the list of qualified expenses covers not only Medicare deductibles, coinsurance, and copays, but also dental and vision expenses (not covered by Medicare), many over-the-counter items (not covered by any insurance), and Medicare premiums (which amount to about $2,000 for the typical Medicare recipient in 2019).
How much of a difference does the rollover make? Let’s create a very simple scenario: You roll over $5,000 from a traditional IRA to an HSA when you’re young. By the time you retire, this amount grows to $20,000. When you retire, you invest it conservatively in your HSA to deliver 2% annual growth. You pay $3,000 per year for Medicare premiums, a figure that rises 4% annually.
You can pay 75 months of Medicare premiums with the HSA funds that you distribute tax-free from your HSA. In contrast, the same money withdrawn from an IRA and taxed at 20% lasts only 60 months. Total premiums paid from the HSA in Months 61-75 are just over $5,000 in this scenario. Does that figure sound familiar?
You can play with the numbers to create slightly different outcomes. Will your tax burden be less than 20% in retirement because you live in a state that doesn’t assess income taxes? If so, funds from an IRA will last longer and the difference won’t be as stark. But if you live in retirement in a state that assesses income taxes and you plan well enough for retirement that you’re in a high (perhaps 24%) federal tax bracket, the difference will be greater. At 30% total taxes, for example, you’ll have to use other funds to pay a portion of the premium in month 54 and every month thereafter.
And HSAs offer other benefits as well. When your funds are in an HSA, they’re not subject to Required Minimum Distributions (RMDs. Beginning in the year that you turn age 70½, you must begin to make withdrawals from traditional IRA (as well as a traditional 401(k) plan). The amount depends on your total retirement balances and expected lifespan. You don’t technically have to make the withdrawals, but if you don’t, you’re assessed a tax of 50% of the RMD amount. In other words, if your RMD figure is $20,000 and you want to keep the funds in your IRA because you don’t need the money that year, you can pay a $10,000 tax to keep the $20,000 in your traditional retirement account.
You never have to spend a dime of your HSA balances (though you probably will). Thus, an HSA can be a good estate-planning tool that allows you to pass your funds to loved ones. For more information on estate treatment of HSAs, click here to access the Benefit Strategies Web site, select Health Savings Accounts and click on HSAs and Estates under the heading Details on HSA Topics).
The rollover isn’t cost-free, however. Because your rollover counts against your annual contribution limit, you lose the opportunity to reduce your taxable income in the year that you make the rollover. For example, if you’re under age 55 and enrolled on family coverage, your maximum contribution is $7,000 in 2019. If you roll over $5,000, you lose the opportunity to reduce our taxable income by that amount (thus paying $1,500 more in taxes, assuming a 30% total tax rate). If your employer contributes $100 per month ($1,200 annually) to your HSA, that leaves you with no more than $800 by which you can reduce your taxable income with HSA contributions.
The good news is that the federal government is running a well-advertised sale on federal income taxes. The well-advertised promotional rates extend through 2025 as a result of the Tax Cut and Jobs Act of 2017. Thus, a rollover now will cost you less than it would before 2018 since marginal tax rates are lower.
You also risk financial consequences if you execute a rollover and don’t remain HSA-eligible through the testing period (see below).
A Few Tips
If you’re considering a rollover, there are several factors to consider.
First, do you anticipate a much higher or lower income in the future? The cost of foregoing the opportunity to reduce taxable income through direct HSA contributions is always softened in years of low income (you or a spouse leaves the workforce or starts a business with limited income in the first year). And it’s more costly to forego the immediate reduction in taxable income in a year of atypically high income.
Second, are you close to age 55? If so, delaying a rollover until age 55 will allow you to roll over an additional $1,000 once you reach age 55.
Third, do you anticipate changing from self-only to family coverage soon? That change will double the amount that you can contribute.
Fourth, is your spouse HSA-eligible? If so, you can execute a rollover to your HSA one year and your spouse can do so into his or her HSA in another year. You’ll lose the opportunity to reduce your table income for two years rather than one, but you can double the amount of retirement money that you move into a tax-free income stream.
Here’s what you need to know to execute an HSA-to-IRA rollover:
Source of funds. The rollover money must come from a single IRA. It can’t be from any other type of retirement account (though you may be able to roll over another account – like a 401(k) plan with a former employer – into an IRA) and it must be a single IRA (you can roll multiple small IRAs into a single account to execute the rollover).
You can roll over funds from a traditional IRA or Roth IRA. But traditional always makes more sense because withdrawals are included in your taxable income and your balances are subject to RMDs. In contrast, Roth IRA distributions are always tax-free (you contributed with after-tax dollars, so you’ve paid taxes already), so you can spend the funds tax-free on anything that you want to buy, not just qualified expenses. And Roth IRA balances aren’t subject to RMDs.
One rollover per lifetime. You’re limited to one rollover per lifetime. The lone exception is if you roll over funds and then change your contract status from self-only to family during that same year. In this case, you can make a second rollover to increase your total amount rolled over to your maximum HSA contribution for that year.
Testing period. You must remain HSA-eligible for 12 full months after the month in which you execute the rollover. For example, if you read this article, take immediate action, and complete your rollover in early May, you must remain HSA-eligible through May 1, 2020. Otherwise, your entire rollover amount is considered a premature rollover from an IRA and is subject to taxes and, if applicable, penalties for premature withdrawal from an IRA.
What We’re Reading
What’s going on in the HSA world, and how can advisors work with employers and HSA owners to maximize the benefits that owners derive from their accounts? Check out this article, which includes advice from my friends Roy Ramthun and Paul Fronstin.
Amazon continues to venture into health care with its new HIPAA-compliant Alexa initiative. Learn more here.