Does Your New Year's Resolution List Include an IRA-to-HSA Rollover?
by William G. (Bill) Stuart | originally posted here
You can roll over funds from an Individual Retirement Arrangement to a Health Savings Account. The rollover delivers some important benefits, but be sure to weigh the hidden costs before you decide to proceed.
Under federal tax law, people eligible to fund a Health Savings Account can make a once-per-lifetime rollover from an IRA to a Health Savings Account. There is a good reason to do so, and a bad reason.
Good reason: You want to move funds from an account whose distributions are included in taxable income (a traditional IRA) to one whose withdrawals for qualified medical expenses are tax-free (a Health Savings Account). This strategy extends the spending power of your retirement funds, doesn't expose them to Required Minimum Distributions, and doesn't affect your future Medicare premiums or taxation of your Social Security benefits.
Bad reason: You're a new Health Savings Account owner and you've incurred a large bill. You want to pay it, and your IRA is a good source of quick cash. This reason is bad because you're spending a retirement asset on a current expense, leaving you with less money in retirement. A better solution is to negotiate repayment terms with the provider, take a personal loan, or sell an asset so that your retirement assets aren't diminished.
The Mechanics of the Rollover
You're entitled to make one rollover per lifetime. The rollover counts against your annual Health Savings Account contribution limit, so you must be HSA-eligible in the year that you execute the rollover. The funds must be rolled over from a single IRA. You may need to consolidate several IRAs or move funds from another type of account (like a SIMPLE, a SEP, or a 401(k) plan) to an IRA if permitted under federal tax law.
Once you complete the rollover, you must remain eligible to fund a Health Savings Account for a full 12 months (a span known as the testing period. Otherwise, your entire rollover (not a pro-rated portion) is considered a premature withdrawal from an IRA and subject to income taxes and possible penalties.
When to Execute a Rollover
Because the rollover can't exceed your annual contribution ceiling, it's important to consider the timing of your action. If you expect your contribution limit to increase soon (you plan to switch to a family contract, you're about to turn age 55 and thus are eligible to make a $1,000 annual catch-up contribution, or your employer is eliminating its $1,500 company contribution), you may want to wait until that time.
On the other hand, if you expect to switch from family to self-only coverage or lose your eligibility to fund a Health Savings Account in the next year or two, now is the time to act.
The Hidden Cost of a Rollover
There is a cost to executing a one-time rollover from an IRA to a Health Savings Account. Every dollar rolled over reduces by a dollar the amount that you can contribute to reduce your taxable income during the year of the rollover.
Example: You're age 55 or older and covered on a family plan in 2021. Your contribution limit is $8,200. Your employer contributes $1,200, leaving you with $7,000 that you can deposit. You roll over $7,000 from your IRA to your Health Savings Account. At your federal income tax rate of 22%, state income tax rate of 5%, and payroll tax rate of 7.65%, you forego tax savings of $2,425.50 (34.65% of $7,000).
The corresponding benefit is that you now have more control over that $7,000. You no longer have the federal government as a partner, telling you when you must begin to withdraw the funds (by age 72) and collecting a portion of all distributions (taxable as ordinary income). It may be worth assuming a higher tax liability during one of your working years to, in effect, purchase tax-free status for a portion of your retirement savings.
It's important that you understand this tax price. There may be a more fortuitous time - for example, your federal marginal tax rate declines one year because your spouse returns to school, or you are laid off - to execute the rollover to minimize your tax liability. If now isn't the right time, it would be prudent to think about what life changes might trigger a change in your tax situation that would make it financially attractive to roll over funds. Then, if that change occurs, you're ready to pounce.
I'm director of strategy and compliance at Benefit Strategies, LLC, a provider of Health Savings Accounts and other tax-advantaged benefits. You can read my biweekly Health Savings Account GPS blog and subscribe by clicking here and my weekly HSA Monday Mythbuster and HSA Wednesday Wisdom columns, as well as my occasional Healthcare Update column, on LinkedIn. My book, HSAs: The Tax-Perfect Retirement Account, is the definitive guide to navigating the intersection of Health Savings Accounts, Medicare, and retirement planning. It's available in book and e-book forms from Amazon.
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