Why HSA Owners Don't Have to Worry about RMD's Harming Their Finances

Required Minimum Distributions can blow up a sound tax strategy. But Health Savings Account owners don't face this potential detonation.

Our first four columns in August are devoted to lesser-known tax benefits that Health Savings Accounts offer their owners. Most readers are familiar with the slogan that these accounts are triple-tax-free, that is,

• Contributions are pre-tax or income-tax deductible,
• Account growth is tax-deferred/tax-free, and
• Distributions for qualified expenses are tax-free.

But Health Savings Accounts offer four other tax benefits. They are:

1. Contributions aren't subject to federal payroll taxes when the money flows through an employer's Cafeteria Plan (Aug. 3, see here)
2. Owners aren't required to make a minimum distribution annually (today).
3. Withdrawals don't affect Medicare premiums (Aug. 17).
4. Withdrawals don't affect taxation of Social Security benefits (Aug. 24).

Required Minimum Distributions

Individual Retirement Arrangements (IRAs) and 401(k) [and similar workplace] retirement plans are billed as individual accounts. That's true in the sense that, for example, spouses don't co-own a retirement account. Each account is owned by only one individual.

But most retirement accounts include a second partner, if not owner. That partner makes certain demands of the owner, backed by the force of law. One of those requirements is that the owner distribute a certain portion of the balance each year, regardless of financial need.

This partner is the federal government. And the mandatory withdrawals are called Required Minimum Distributions, or RMDs. RMDs apply to all tax-deferred accounts, beginning in the year that the owner turns age 72.

Example: You're age 75 and have a balance of $750,000 at the end of 2022 in your various tax-deferred retirement accounts. You must withdraw at least $30,500 in 2022 or face a penalty equal to 50% of the amount of the RMD that you didn't withdraw. Thus, if you wanted to make no distributions from any tax-deferred account in 2022, you'd pay a penalty of $15,250.

Here's the official calculator that you can use to determine how much you must withdraw at a certain age with a certain total balance in your tax-deferred accounts.

The Rationale behind RMDs

Why does the federal government mandate withdrawals? During the accumulation phase, when you fund your tax-deferred accounts, your contributions are free of income taxes. The government defers income taxes to encourage you to save more for retirement. After all, you're more likely to contribute an extra $100 monthly if it reduces your take-home pay by only $70, rather than the full $100.

The reward for the federal government is that as the $100 grows to $500 or $900 over time, income taxes will be applied to all withdrawals. The federal treasury benefits when the higher value eventually is taxed. In effect, the government forgoes taxes on the seed and instead taxes the crop when it's harvested.

RMDs ensure that the federal government begins to receive its stream of income taxes. Otherwise, retirement-plan owners who don't need funds from their tax-deferred accounts may avoid withdrawals in some years. That's not good for the health of the federal treasury. Thus, RMDs.

Are RMDs a Problem for Taxpayers?

Most Americans haven't accumulated sufficient balances to fund a secure retirement. In these situations, they must withdraw more than the required minimum each year just to pay their expenses. Thus, RMDs rules often don't affect them directly.

For some owners, though, RMDs can create a wealth or tax problem. Consider these situations:

• A retiree simply doesn't need the full amount of the RMD to fund her lifestyle. This is especially true as retirees age and travel less. The same retiree in our example above may see her tax-deferred IRA balance decline to $500,000 by age 85, when she's living with her son and supporting herself on her Social Security benefit or a pension. She must withdraw a minimum of $31,250 from her tax-deferred account in her 85th year. Even if she's in the lowest federal marginal income tax bracket, she'll pay an additional $3,750 in taxes.
• The value of an owner's tax-deferred accounts declines by 10% due to a bad year in the stock market. She wants to retain her balances so that she has more money in the account to take advantage of the next market upswing. She can close the gap in her budget with other funds - savings, the sale of other assets, borrowing from a permanent life insurance policy - without dipping into her tax-deferred IRA balance. But she must take her RMD. In our example above, if her account value declines from $500,000 to $400,000 (a 20% drop), she must realize a 36% increase from $368,750 (her balance after the drop in value and the RMD) to build her account value back to $500,000, rather than 25% if her base is $400,000.
• A retired couple sells a primary residence or business and is flush with cash. They'd rather spend that money than invest it, since the investments would be taxable. They don't need to distribute money from their tax-deferred account for several years. But they have no choice.

In each of these common situations, the tax-deferred retirement account owner doesn't need the income, doesn't want the tax liability, and may face additional Medicare premiums or taxes on Social Security benefits (the topics of our next two HSA Wednesday Wisdom articles).

Health Savings Accounts as the Antidote

Health Savings Accounts aren't subject to RMDs. Thus, owners are never required to withdraw funds that they don't need. They are in full control of their accounts without a silent partner dictating distribution terms with them. This feature allows them to retain their funds to reimburse only qualified expenses, rather than force a distribution and leave the owner scrambling to find enough documentation to offset the withdrawal with current or past unreimbursed qualified expenses to reduce the tax bite.

The Bottom Line

In addition to the triple-tax advantages and contributions that are free of federal payroll taxes, Health Savings Accounts offer their owners total control over the timing and amount of distributions. Owners can limit distributions to qualified expenses, defer reimbursement to preserve balances, or make withdrawals for non-qualified expenses (subject to income taxes, but no additional tax beginning at age 65). Health Savings Accounts, in short, give owners a level of control that retirees age 72 or older with balances in tax-deferred accounts don't enjoy.

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