Introduction:

              “Have a good day at the Renaissance Faire dear.” A 55-year-old woman said to a 55-year-old bald man putting on makeshift chain mail armor.

              “Thank you, Fair Maiden of Orange County, California! Do I look ready?” The bald man responded with somewhat muffled speech due to the paper mâché helmet on his head. Unsure if his wife could hear him over the deafening roll of her judgmental eyes, he repeats, “What say you, Jane? Do I look ready?”

“Yes, John. You look very nice.” John’s wife sheepishly crafts a smile to be supportive of John’s interests.

Jane continues, “When you are out, please check the P.O. Box. Your Traditional Individual Retirement Account (Traditional IRA) and Heath Savings Account (HSA) statements are there. We’re meeting with our financial planner tomorrow and they will need those documents to update our financial plan. They’ll also need to know about your new job you’re starting in two days.”

“Yes, yes. Jane. I know. I will check the P.O. Box on the way there.” John says while sorting out how to maneuver into the driver’s seat of his Toyota Camry while wearing his knight outfit.

“Thank you, John.” Jane responded while waving goodbye to her knight in shining armor.

“I wish you good tidings on your brunch quest with your Fellowship of Sunday Dames.” John exuberantly shouted at Jane while the garage door started to close.

“Yes, John. The girls and I will have fun at IHOP. Just come back home as the serious John, not the goofy John.” Jane said to a closed garage door.

John proceeds to go to the post office and sure enough, the IRA and HSA statements are there. He walks back to his car and sticks the statements in the glove compartment.

He later enjoyed his time at the Renaissance Faire. The festivities ended and John exited the fairgrounds, though he noticed something peculiar next to his car. It was a large man in a knight’s costume painted black leaning on his dashboard.

“Good sir, are you the owner of this chariot?” The knight in black bellowed at John.

“Yes.” John responded.

“You didn’t pay for parking.” The knight in black said in a much less theatrical tone.

“You are mistaken, knight of the fairgrounds. Check your coffers once more.” John responded with darting eyes.

“No, you did not pay. The cameras overhead document my proof of your stinginess.” the obstinate knight in black grumbled as he pointed to some security cameras on a fence post.

“I paid! Now, move!” John said while pushing the knight in black.

“I move for no man.” scowled the knight in black.

“So be it!” John shouted while angrily running at the knight. Between strides, John started to sweat profusely as he began to contemplate his dire situation. The man in the knight’s costume was at least a foot taller than John and had biceps as wide around as John’s pudgy waistline. The knight in black struck John (and his hubris) down with no effort. A loud crunch reverberated around the dirt parking lot as John stared at his flatted left arm.

“’Tis but a scratch.” John said as he got back up while holding his broken arm.

“No, that’s a flesh wound.” The knight responded as he spat on the ground beside John’s feet¹.

The knight sighed, “Just pay the parking fee. You’ve already made me late to my daughter’s dance recital. Don’t make me break your other arm.”

John gave the knight $5 and got in his car and decided to go to the hospital before going home. It took a few hours, but John got all patched up and received his medical bill of $9,550. He decided to turn his radio on while he drove back home.

              Voice over the radio: You’re probably thinking to yourself, “What did all of that have to do with personal finance?” Well, astute readers may have noticed that John and Jane are both age 55 (A person aged 55 or older who is enrolled in a high deductible health plan, or HDHP, can make an additional $1,000 catch-up contribution to their HSA). Also, the medical bill is $9,550 (this is the maximum allowable contribution amount in tax year 2025 for an HSA with family coverage). These are relevant points to the financial planning topic of an IRA to HSA rollover. Trust me, I’m going somewhere with all of this. How about we jump to the meeting with the financial planner, shall we?

Case Study:

              “John. Jane. Good to see you both. What’s new?” The financial planner responded.

              “I finally got a new job! I’ll be making $1,000,000 per year and I start tomorrow!” an enthusiastic John responded.

              “Well, good for you John! Say, is your arm okay? What happened?” The financial planner said as they eyed the plaster cast over John’s left arm.

              “John got into a scuffle at the Renaissance Faire yesterday.” Jane said.

              “Oh, geez. I hope you feel better soon.” The concerned financial planner responded.

              “Thanks, I’m okay. Though we’re stuck with a $9,550 medical bill that we’ll need to pay somehow. I won’t get paid for another month and this medical bill is due now. I don’t want to incur any medical debt.” John responded as Jane put John’s IRA and HSA statements on the financial planner’s desk.

              Here is a breakdown of John and Jane’s cash and investments:

• $10,000 in a checking account
• $19,550 in John’s Traditional IRA with an after-tax basis of $10,000
• $1,000 in John’s HSA
• $20,000 in Jane’s 401(k)

              “We’re looking to pay for the medical bill from either from cash on hand, John’s IRA, John’s HSA, or Jane’s 401(k). I’m recommending that you pay it from John’s HSA. Distributions from an HSA are tax-free if used for qualified medical expenses.”

              “But there’s only $1,000 in the HSA. Why not pay the bill from the funds in the Traditional IRA? How can we even pay from the HSA?” Jane asked.

              “We’ll, John hasn’t yet contributed to his HSA and is signed up under a high deductible health plan with his new employer. Tomorrow, John can make the full $8,550 family coverage contribution plus an additional $1,000 contribution because he is over age 55. He would make that contribution by rolling over the money from his IRA into his HSA. This is formally called a Qualified HSA Funding Distribution (QHSAFD).” The financial planner responded.

              “What if John had already contributed to the HSA?” Jane asked.

              “In that case, the rollover amount would be reduced by what he already contributed into the HSA for the year.” The financial planner responded.

              “This seems complicated. Why not just take the funds from the Traditional IRA? Wouldn’t this be considered a qualified medical expense?” Jane asked the financial planner.

              “You could do that, but it most likely wouldn’t be considered a qualified medical expense. The reason for that is John now makes $1,050,000 per year at his new job. Your adjusted gross income (AGI) is projected to be $1,000,000 and this $9,550 medical bill would only be itemizable if and only if your total unreimbursed medical expenses exceeded 7.5% of AGI (or $75,000). Since a Traditional IRA distribution of $9,550 would not be considered a qualified medical expense in your case, the $9,550 distribution would be considered taxable. You also would be subjected to a 10% federal early withdrawal penalty and 2.5% California early withdrawal penalty for taking an IRA distribution under the age of 59.5. Since there is a non-deductible basis in your Traditional IRA of $10,000, the distribution would be subjected to the pro-rata rule. This means that even though not all the distribution would be taxable, some still would be taxable. There is a formula for determining the taxable amount. The taxable amount of the distribution is:

              $10,000 (the after-tax basis) / $19,550 (the total amount in the IRA) = 51.15% (the percentage of your IRA that is after-tax basis).

              51.15% x $9,550 (the distribution amount) = $4,884.82 (the non-taxable amount of the distribution)

              $9,550 – $4,884.82 = $4,665.18 (the taxable amount of the distribution)  

With that in mind, here’s your projected tax bill when comparing the early withdrawal vs taking the distribution from the HSA.” The financial planner responded.

              “The difference in taxes for you is an additional $2,192 Fed and $527 State, or $2,719 total for the early withdrawal scenario.”

“That’s a lot to keep track of. I guess that’s why you’re in business.” John responded.

“I’m always happy to replicate all of the data presented here at your request.” The financial planner said.

              “I’ll keep that in mind. Well, why don’t we just pay for the medical bill in cash?” John questioned.

“Yes, you could pay for the medical bill in cash. Though I recommend that you always keep at least 3-6 months of living expenses in cash for emergencies. For you and your spending, this means keeping $50,000 – $100,000 in cash. I would rather have you start saving into your cash bucket rather than depleting it.”

              “Makes sense.” John and Jane said.

“Now here’s where things get really cool (at least cool for us math geeks).” the financial planner responded. “When you do the rollover from Traditional IRA to HSA, you cannot rollover after-tax basis. You have exactly $9,550 in gains in your IRA. That gain is what we will be able to put into the HSA tax-free. This leaves you with $10,000 in an IRA made up of 100% basis. Of course, any future growth in the IRA is going to be subjected to taxation and the pro-rata rule. What if I told you that you could potentially make all that future growth tax-free?”

“We’re listening.” John said while he smirked.

“You can take your Traditional IRA and convert it to a Roth IRA. Normally, a Roth Conversion is a taxable event. However, the taxation on any Roth Conversions is only applied to investment growth in the Traditional IRA or any deductible basis. It does not apply to the basis in the Traditional IRA. Therefore, after doing the IRA to HSA rollover, we can move the remaining $10,000 within the Traditional IRA account and convert those funds into a Roth IRA. The Roth IRA grows tax-free if the account has been opened for 5 years, and you withdraw the funds after age 59.5. You can read more about these topics here if you are interested.” the financial planner concluded.

“We have $20,000 in my 401(k), why don’t we just take the money from there?” Jane asked.

“That question’s a little easier to answer. You can’t do a 401(k) to HSA rollover. You would also most likely be subjected to the early withdrawal penalty and all the distribution would be considered taxable because the pro-rata rule does not apply to 401(k) (or qualified plan) assets.”

“Are the any rules we need to keep in mind with the IRA to HSA rollover?” John asked.

“Yes. There is a 12-month testing period. This means that after doing the IRA to HSA rollover, you need to stay in the same high deductible health plan for at least 12 months. If you don’t there may be taxes and penalties incurred from doing the IRA to HSA rollover.”

              “Thank you for that. All this sounds good. Let’s get this strategy started. My arm feels better already. Thank you!” John responded.

              “Thank you for your help.” Jane echoed.

              “You’re welcome.” The financial planner responded.

Conclusion:

              I know that this was a pretty nuanced topic, but hopefully I illustrated how sometimes financial planning isn’t as cookie-cutter as you might think. Sure, John and Jane could have just taken the tax hit or waited to pay the medical bill after John’s salary started hitting their bank account and would have been fine in the long run. Using the strategies laid about above helped them avoid medical debt and save on taxes today and tomorrow. I just wanted to have some fun (yes, I probably need to go outside more if I think this is fun) and show how intricate tax-focused financial planning can help save people money over their lifetimes. If you would like to schedule a free consultation with one of our Certified Financial Planner™ professionals, please give us a call at 714-282-1566 or email us at financialplanning@bfsg.com. We look forward to helping you prioritize your financial goals through comprehensive financial planning.

Footnotes:

1. I’m loosely basing this interaction from a scene in Monty Python and The Holy Grail (1975). If you haven’t seen it, it’s a classic for a reason.

Sources:

1. https://www.fidelity.com/learning-center/smart-money/ira-to-hsa-rollover
2. IRA-to-HSA Rollovers: Tax-Free Medical Savings – Retirement Daily on TheStreet: Finance and Retirement Advice, Analysis, and More
3. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-exceptions-to-tax-on-early-distributions
4. https://www.lordabbett.com/en-us/financial-advisor/insights/retirement-planning/funding-an-hsa-with-an-ira–a-once-in-a-lifetime-opportunity.html

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