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Roll This Way

Richard Connor

I THOUGHT I HAD a pretty good handle on health savings accounts, or HSAs. My wife and I contributed to HSAs over the decade before we retired. The money we accumulated has come in handy in the early years of retirement. I’ve also written several articles extolling their virtues.

But I recently learned that we missed an opportunity to further fund these accounts, while simultaneously reducing future required minimum distributions. The trick is to do a rollover from an IRA to an HSA. The tax code allows a once-in-a-lifetime IRA-to-HSA rollover. This little-known strategy is called a qualified HSA funding distribution. It appears that Congress authorized this as a way for a taxpayer to access IRA funds for a onetime significant medical expense.

Direct rollovers are allowed from a regular IRA, but not from a SEP or SIMPLE IRA. You also can’t do a direct rollover from an employer-based account, such as a 401(k), 403(b) or 457. But you could roll over funds from your employer-based account to a rollover IRA, and then do the direct transfer to your HSA.

To contribute to an HSA, you must be enrolled in a high-deductible health plan, or HDHP. Contributions to HSAs are tax-deductible and any subsequent growth is tax-deferred. Withdrawals from your HSA that are used to pay qualified medical expenses are tax-free. This is unlike withdrawals from a traditional IRA, which are considered taxable income.

For individuals with an HDHP in 2023, the maximum contribution to an HSA is $3,850, while the maximum contribution for those with family coverage is $7,750. There’s an additional $1,000 catch-up contribution allowed for those age 55 and older. Consider a married couple, both 55 or older, with an HDHP through one spouse’s employer. In 2023, they could contribute up to $9,750—a $7,750 family contribution, a $1,000 catch-up for the insured and another $1,000 to the other spouse’s HSA. 

Converting funds from a traditional IRA to an HSA, and then using them for future qualified medical expenses, has the effect of eliminating the tax owed on the sum involved. It also has the added benefit of shrinking your IRA balance and thereby reducing future required minimum distributions.

The maximum amount you can roll over is the same as that year’s HSA limits on contributions based on your age and type of coverage. In other words, any amount rolled over reduces the amount you can contribute directly to your HSA for that year. This includes any contributions your employer makes on your behalf.

The strategy is covered by strict rules, so you need to do your homework. The rollover is reported on line 10 of IRS Form 8889. One of the more complicated parts is the testing period. You must remain eligible for an HSA during a 12-month testing period, which begins in the month you make the rollover and ends 12 months later on the last day of that 12th month, with the distribution month counting toward the 12-month total.

Got that? For example, if you did a rollover on June 17, 2023, the testing period would end on June 30, 2024. If you fail the testing period—there are exceptions for death or disability—the entire amount that was rolled over becomes taxable income and subject to a 10% tax penalty.

Who does this make sense for? A good candidate would be a married couple, over 55, enrolled in a family coverage HDHP, with existing HSAs. Let’s assume the HDHP is through the wife’s employer. She could roll over the maximum amount—$8,750 in 2023—to her HSA. Her husband could also roll over $1,000 to his HSA, for a total of $9,750.

If the couple has individual HDHP health insurance coverage, they could each roll over the maximum individual amount into their own accounts. They can even share the maximum amount unevenly, but the IRS rules for splitting HSA contributions between a married couple are complicated, so you need to make sure you follow the rules carefully. Of course, a single person can also use this up to the individual maximum amount.

This once-in-a-lifetime conversion has the impact of a Roth IRA conversion, but without the current income tax burden. Adding an additional tax-free $9,750 to an HSA may not seem like a lot, but it could help cover some medical expenses if you’re an early retiree who isn’t yet age 65 and eligible for Medicare.

In addition, I could see using this tactic in conjunction with a Social Security claiming strategy, where the higher-earning spouse delays his or her benefit, while the other spouse claims earlier. The additional HSA funds could cover several years of a retiree’s future Medicare premiums, which are considered an eligible expense for tax-free HSA withdrawals.

Unfortunately, my wife and I missed the boat on this opportunity. Vicky retired in July 2021. I started Medicare in September 2022. During the intervening 13 months, we purchased an HDHP health plan through my old employer. We could have done at least a partial rollover, based on our months of coverage.

But who says you have to do a rollover? Researching the rollover strategy made me consider an alternative approach for some pre-Medicare retirees. Here’s how it might work:

  • Married couple, 60 years old, filing a joint tax return
  • Enrolled in an HDHP and have HSAs
  • Instead of rolling over IRA money to an HSA, they withdraw $9,750 from an IRA, avoiding the usual 10% tax penalty because they’re over age 59½
  • Use that money to contribute $9,750 to health savings accounts
  • Take $9,750 HSA deduction on Form 8889 when they file their taxes
  • Recover any tax withheld as a tax refund

Result? Their HSA contributions are tax-deductible and thus reduce their taxable income—and that means the IRA withdrawal is effectively tax-free.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.

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