When does the IRA-to-HSA Rollover Make Sense? When Is It Ill-Advised?

Rolling over assets from an Individual Retirement Arrangement to a Health Savings Account is permitted. But that doesn't mean it's advisable in many situations.

If you're eligible to fund a Health Savings Account, you can execute a rollover from an IRA. It's not a complicated process, and you alone (your employer isn't involved, even if you opened your Health Savings Account through the company) weigh the benefits and complete the transaction with the help of your IRA and Health Savings Account providers.

Its\'s not complicated, but there are rules to follow and penalties for failing to execute the rollover properly. So be sure you understand the benefits and potential pitfalls before you act.

The Rules

Health Savings Account owners are permitted to make a once-per-lifetime rollover from an IRA to a Health Savings Account. Here are the rules:

• The funds must come from a standard IRA - not a SEP IRA, SIMPLE IRA, or another type of retirement account like a 401(k) plan, 403(b) plan or 457 plan (although you may be able to roll over balances from one of these accounts to an IRA, then execute a rollover to a Health Savings Account).
• The rollover is limited to the statutory maximum annual contribution, which in 2022 is $3,650 for self-only coverage and $7,300 for a family plan (plus an additional $1,000 if the owner is age 55 or older).
• The owner must be eligible to open and fund a Health Savings Account and must remain eligible to do so for 12 months following the month of the rollover. This 12-month period is referred to as the testing period. If the owner fails to remain HSA-eligible, the full amount of the rollover is included in her taxable income and subject to an additional 10% tax as a penalty.

The Benefits

The biggest benefit of the rollover is that owners can move funds from a taxable stream (withdrawals from a tax-deferred IRA are always included in taxable income) to a tax-free stream (distributions from a Health Savings Account for qualified expense are never included in taxable income). In retirement, this difference not only lowers taxes, but it can eliminate Medicare Part B and Part D premium surcharges and the percentage of Social Security benefits included in taxable income.

Another benefit is to owners facing an immediate medical bill (say an expensive drug, where it's rarely possible for a patient to negotiate a repayment plan) whose only source of funds is an IRA. They can avoid taxes and penalties on a premature withdrawal from an IRA by rolling over the sum to a Health Savings Account, then paying the bill with a withdrawal from the Health Savings Account. But if that bill is from a doctor or facility, patients can usually negotiate repayment terms. It's far better to preserve assets and pay a monthly bill until the balance is paid. If you drain your 401Kk)/Health Savings Account with the intention to repay that amount, you'll join most Americans if you find that you consistently have "too much month at the end of the money" and end up never replenishing the asset.

The Cost

But this rollover doesn't come with financial consequences. Every dollar rolled over represents a dollar of current income that can't be reduced with Health Savings Account contributions.

Example: You are under age 55 with family coverage and earn $62,000. Your company contributes $1,500 to your Health Savings Account. You roll over $5,800 (your $7,300 maximum contribution less your employer's $1,500) from your IRA to your Health Savings Account. You can't contribute any more to your Health Savings Account that year. Thus, you're taxed on $62,000 of income rather than $56,200. You pay an extra $2,000 in taxes (assuming a 22% federal and 5% state marginal income tax rate, plus payroll taxes).

Thus the trade-off: You expose more of your income to taxes. In effect, you pay more taxes now in exchange for moving the funds into an account from which you can make tax-free withdrawals in the future.

Of course, in the example above, you now have an additional $5,700 of income that you otherwise may have contributed to your Health Savings Account. You can shelter it from income (but not payroll) taxes now by making additional deposits into your tax-deferred workplace retirement plan. You enjoy immediate tax savings, although withdrawals (including growth) are taxed as ordinary income when distributed.

Alternatively, you can forego the immediate tax savings and fund a Roth account, either through your company (if it offers this option) or on your own through an IRA. The income is still taxed, but distributions (including investment gains) are tax-free in retirement.

On the other hand, if you hadn't planned to fund your Health Savings Account (or had planned to contribute much less than the statutory maximum), your tax savings foregone are much less.

"Don't Eat the Seed"

The third option is to enjoy an additional $3,700 (after paying taxes) in your pocket and travel, buy a motorcycle, or contribute to a charity (in which case you enjoy tax savings). But this approach represents what's generally a poor bargain: You are, in effect, redirecting money that you otherwise would save for retirement and spending it on current consumption.

Let's review: Rolling over money from your IRA to your Health Savings Account doesn't increase your total assets. It merely shifts a portion of those assets to an account with favorable tax benefits. If you spend that money, you're reducing your asset base. If you preserve those balances but spend money that you otherwise would have contributed to your Health Savings Account to pay for qualified expenses in retirement, you're reducing your potential assets. Either way, you're like the farmer who consumes seeds during the winter rather than planting them in the spring to enjoy a robust harvest in the fall.

The Bottom Line

The lessons to carry from this column:

• A rollover from a traditional IRA to a Health Savings Account will extend the spending power of the amount of the rollover in retirement, since you can withdraw it tax-free for qualified expenses.
• The only time it makes sense financially to spend the rollover funds is if you otherwise would have executed a premature distribution from your tax-deferred IRA and paid taxes and penalties on the withdrawal.
• Consider redirecting Health Savings Account contribution that you can't make (because the rollover offsets what you can deposit that year from current income) to another asset like a retirement plan. That way, you continue to build your assets for retirement. Don't be fooled into thinking that the rollover increases your wealth (although it does generate more future spending power from those funds that were in the tax-deferred account.
• Consider the cost of the rollover in terms of immediate tax savings that you don't enjoy because the amount of the rollover reduces the taxable income that you can shelter from income and payroll taxes now.

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