Back-Door Roth IRA? Why Not Walk through the Front Door of an HSA?

Back-Door Roth IRA? Why Not Walk through the Front Door of an HSA?

A recent surge in articles about back-door Roths touts the advantages of Roth versus tax-deferred retirement accounts. But the tax savings associated with a Health Savings Accounts trump them both.

Some financial professionals are counseling their clients to open a back-door Roth IRA to diversify their tax risk in retirement. The strategy involves paying taxes now to enjoy tax-free distributions in retirement. But there's another way to achieve tax-free withdrawals in retirement without paying income (and payroll) taxes now.

This other way involves a Health Savings Account. Many financial advisors don't understand the power of these accounts. But in a few minutes, you will.

The Difference Between Tax-Deferred and Roth

Tax-deferred 401(k) plans and Individual Retirement Arrangements (IRAs) have been around for more than four decades. These plans allow Americans to fund retirement accounts with pre-tax (401(k) plans) or tax-deductible (IRAs) contributions. With no federal or state taxes applied to contributions, each $100 of sacrifice of current consumption will result in a $92.35 (the 7.65% federal payroll taxes aren't waived) contribution for most taxpayers. If contributions were taxable, the deposit would be closer to $75. Thus, this tax treatment allows participants and account owners to amass larger balances more quickly.

Growth from investing balances is tax-deferred. But all distributions are included in taxable income. And beginning at age 72, account owners must make Required Minimum Distributions (RMDs). A formula based on age and account value determines the annual RMD. These distributions are mandatory because the federal government wants to begin to realize tax revenue on these funds. [Technically, they're not mandatory per se. If your RMD is, say $20,000 in 2022, you can pay a $10,000 penalty and retain the $20,000 in your retirement account.]

Roth Accounts are a newer form of saving, dating back to the late 1990s. The tax treatment is the reverse of tax-deferred accounts. Contributions are post-tax (so the $75 figure above is a general representation of how much of a $100 sacrifice of current income will produce in contributions after paying federal and state income taxes, plus federal payroll taxes). Growth is tax-deferred/tax-free. All qualified distributions (essentially, withdrawals after age 55) are tax-free. There are no RMDs associated with a Roth IRA, since federal and state governments have already taxed the money during the contribution stage. [Note: Roth 401(k) balances are subject to RMDs, so it may be advisable from a tax perspective to roll over funds from a workplace Roth to a Roth IRA if possible.]

The Roth Advantages

The Roth advantages are simple:

  • Tax the seed, not the crop. Since balances normally grow over time, taxing retirement money at its low point (contributions) rather than at its high point (distributions after decades of account growth), Roth accounts are more tax-efficient. But the deductibility of contributions to tax-deferred accounts allows savers to build larger retirement balances. It's a balancing act.
  • Control withdrawals. Since Roth IRAs aren't subject to RMDs, owners have control over distributions. Don't need the money in a given year? Don't withdraw any funds. The value of your Roth IRA declined? Keep your funds in the account and draw money from another account (cash? borrowing against permanent life insurance?) to pay your bills.
  • Diversity your tax risk. Savvy retirement planners understand the importance of diversifying their investments. Classes of assets - such as large company stocks, real estate, international stocks, and corporate bonds - perform very differently year-to-year. Diversifying smoothens the ride. Tax policy is subject to political forces, which may result in decreases in marginal tax rates (the 2017 Tax Cut and Jobs Act put personal income tax rates on sale through 2025) and proposals to raise rates). Retirement investors whose nest eggs are held in tax-deferred accounts only may find tax rates applied to their distributions that are very different from what they envisioned. Placing a portion of retirement savings in Roth accounts results in tax certainty, as income taxes are levied on contributions, when the applicable tax rate is known, and not on future withdrawals when rates aren't yet established.

Entering the Roth Back Door

What is a back-door Roth funding strategy? The opportunity to fund a Roth IRA is restricted based on income. For example, a couple filing taxes jointly with an adjusted income greater than $208,000 can't contribute to a Roth IRA - even if they're willing to pay taxes on their contributions and thus fund federal and state government current expenses.

You can, however, fund a tax-deferred IRA, then convert that money to a Roth account. You must follow a procedure and some simple rules, plus include the amount of the conversion in your taxable income that year.

Example: You're not eligible to fund a Roth IRA based on your income. You contribute $6,000 to a tax-deferred IRA, then almost immediately convert the balance to a Roth account, including the $6,000 in your taxable income for that year. The net result: You paid the income taxes you would have owed had you contributed directly to a Roth IRA and enjoy future tax-free growth and tax-free withdrawals from the Roth account.

There are some rules that you must follow about withdrawing funds within the first five years after the conversion. So, conversions generally aren't a do-it-yourself project and may not be practical for people who will need to access their funds within five years.

Enter Health Savings Accounts

There is another way to achieve the benefits of a Roth IRA without incurring a tax liability on contributions: Open and fund a Health Savings Account. That's right. The most flexible healthcare reimbursement account is also act as the most tax-efficient retirement account.

Unlike tax-deferred (distributions) and Roth (contributions) IRAs, Health Savings Account deposits are never subject to income taxes (nor payroll taxes if deposited through a company's Cafeteria Plan) and withdrawals for qualified expenses aren't included in taxable income. In other words, Health Savings Accounts offer the best tax features of both types of IRAs. Health Savings Account owners don't weigh the certainty of today's tax rates versus the uncrtainty of future rates. They don't need to determine whether they want to incur the tax liability now or in the future. Their contributions and distributions for qualified expenses are both free of income taxes.

Here's how to leverage the power of Health Savings Accounts to minimize tax friction:

  1. Fund your workplace tax-deferred retirement account to receive the full employer match. Those matches represent an instant return of 50% to 100%.
  2. Divert additional retirement contributions to a Health Savings Account. Then commit not to spend those funds (otherwise, you'll spend your retirement savings prematurely).
  3. Pay qualified Health Savings Account expenses with personal (after-tax money). Your employer may offer a Limited-Purpose Health FSA, which allows you to reimburse dental and vision expenses tax-free.

When you follow this strategy, you in effect build your retirement savings with the combined tax advantages of a tax-deferred account (no income taxes assessed on contributions) and a Roth account (no income tax liability on distributions, with the caveat that the withdrawals must be for qualified expenses). When the three options - tax-deferred, Roth, and Health Savings Accounts - are modeled over 30 years of contributions, then distributions (adjusted for inflation) until the funds are exhausted, Health Savings Account balances last roughly two years longer than the other accounts'. In other words, the same sacrifice of current income can produce an additional two years of covering retirement medical expenses if placed in the most tax-efficient account.

Actually, the tax benefits are even a little better. Payroll taxes (7.65% for most Americans) are applied to all contributions to a tax-deferred account (tax-deferred in this context refers to income taxes only), but not to Health Savings Account contributions. If you contribute $5,000 to a Health Savings Account rather than a tax-deferred retirement account, you save $382.50 in taxes.

That may not sound like much. But if you save $382.50 annually in payroll taxes and begin to invest at a 6% return once you meet a $1,000 investment threshold in a typical Health Savings Account, you gain more than $14,000 in additional balances after 20 years and more than $30,000 after 30 years.

To put that figure in perspective, the average Medicare enrollee spent almost $6,200 in 2018 for premiums, Medicare cost-sharing, and services (like dental and vision) not covered by Medicare. If we raise that figure to $7,000 to factor in inflation, these payroll-tax savings from diverting contributions from a tax-deferred account to a Health Savings Account cover two years of retirement out-of-pocket after 20 years and four years' worth after 30 years.

Imagine the peace of mind that accompanies covering those expenses without dipping into other retirement assets.

Oh, and those expenses that you reimbursed with taxable funds to preserve your Health Savings Account balances? You would have used taxable funds in the absence of a Health Savings Account. And if you keep good records, you can reimburse those expenses at any point in the future - such as after the seeds have grown for decades - without incurring a tax liability.

The Bottom Line

Health Savings Accounts are a great way to save between 20% and 35% on all qualified expenses. But they also eliminate the tax friction on one end or the other of tax-deferred and Roth account contributions and distributions. Leveraging a Health Savings Account for retirement contributions gives owners more spending power for qualified healthcare expenses in retirement. That's peace of mind.

#HSAWednesdayWisdom #HSAMondayMythbuster #HSA #HealthSavingsAccount #TaxPerfect #yourHSAcademy #yourHealthSavingsAcademy

William G. (Bill) Stuart

Nationally recognized expert on reimbursement account strategy and compliance, particularly Health Savings Accounts and ICHRAs 🔹Writer🔹Author🔹Speaker🔹Educator🔹Strategist

1y

Going through the Health Savings Account door is often better financially than sneaking through the Roth "back door."

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