Tackle Higher Medical Expenses and Tax Infested Traditional IRA Accounts at the Same Time!

By Ryan McKeown, CFP, CPA
Wealth Enhancement Group®
Follow Wealth Enhancement Group® on Twitter: @WealthEnhance
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Two challenges that retirees and pre-retirees are facing are rising medical costs as well as trying to figure out how to distribute their tax deferred retirement accounts, such as Traditional IRAs with the least amount of tax possible.  There is a strategy that can “tackle” both challenges at once! 

The strategy that can be used between the age of 59-1/2 and typically age 65 (at the time Medicare is in enrolled in) is to take additional withdrawals from your tax deferred Traditional IRA account and make a corresponding Health Savings Account contribution within the same tax year as the distribution.  The Traditional IRA withdrawal is considered taxable income, but not subject to the 10% pre age 59-1/2 penalty any more.  The Health Savings Account contribution is a deduction that will offset the taxable income from the Traditional IRA withdrawal.  By using the cash from the Traditional IRA withdrawal to fund the Health Savings Account contribution, it is like you are indirectly shifting tax infested Traditional IRA assets to more tax friendly HSA assets that can be used tax free for qualified medical expenses. 

Here is an example how this is implemented in real life:  Joe IRA turned age 59-1/2 on July 1st, 2016, and is also participating in a high deductible health plan (HDHP) which allows him to make contributions to an HSA. He can take a distribution before December 31st, 2016 from his Traditional IRA (don’t take any taxes out), then use those funds to make a contribution in the same amount to a HSA prior to April 17, 2017.  Joe would perform this transaction in an amount equal to the maximum HSA contribution amount for that year.  The contribution amount in 2016 for a single plan in $4,350 ($3,350 plus a $1,000 catch up for being age 55 or older), for a family plan $7,750 ($6,750 plus a $1,000 catch up for being age 55 or older). 

If Joe repeats this process until he is age 65, assuming contribution amounts stay the same for example purposes, he could make 6-1/2 years of contributions.  He only gets to contribute ½ year the year he turns 65, assuming he enrolls in Medicare on July 1stthe year turns 65, which limits his ability to contribute to an HSA because Medicare is not a high deductible health plan.  This is $28,275 worth of contributions if he is on a single plan, $50,375 if he is on a family plan.  That is pretty significant tax savings considering if these funds would have stayed in the Traditional IRA, they would have to be taxable as ordinary income eventually!  Joe would also have more liquid savings available outside of his tax deferred accounts because he would not have to use non-retirement funds to make the contributions.

If the funds are not used for qualified medical expenses, after age 65 distributions are not tax free from the HSA, but are not subject to a 20% penalty which makes the tax treatment the same for non-qualified HSA distributions as Traditional IRAs except for one key difference:  HSAs are not subject to required minimum distributions like Traditional IRAs are, which makes HSAs  inherently superior.  With rising health costs, most will not have trouble finding qualified expenses for tax free withdrawals though.

For those under age 59-1/2, this strategy is not as effective because the Traditional IRA withdrawals are subject to the pre age 59-1/2 10% penalty.  The “once per lifetime” transfer from Traditional IRA to HSA can be an effective strategy for those, however, its effectiveness is limited because it is one time in nature.  Those under age 59-1/2 might be best to fund HSA accounts in lieu of Traditional IRA or other tax deferred retirement accounts to build up more funds on a tax favored basis for qualified medical expenses.  In other words, fund your HSA before you fund your 401(k) (outside of what your company matches), or perhaps even your Roth IRA! 

One last spin on this strategy is if Joe separates from service from a company where he has a 401(k) plan in the year he turns age 55  or older, he can take withdrawals from his 401(k) plan without the 10% penalty to assist in funding HSA contributions.  The downside to this is that the 401(k) withdrawals are subject to 20% mandatory federal tax withholding, which leaves Joe short on the cash needed to make the full contribution.  In this situation, Joe would need to come up with funds from other sources to make up for the 20% withholding to make the HSA contribution.  He could potentially recoup some of the withholding through a tax refund when filing for that year, since he would be receiving a full tax deduction to offset the taxable income.

Medical costs are expensive enough.  Don’t make them more expensive by not using the most tax advantaged strategies available to help pay for them. 

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Contact information:

Kristin Kopic, CRPC® | Marketing Manager – Content and Brand
Wealth Enhancement Group®
505 N. Hwy 169 | Suite 900 | Plymouth, MN 55441
p. 763-417-1604 | f. 763-417-1605 | [email protected]
Ryan McKeown, CFP®, CPA | Sr. VP – Financial Advisor
Wealth Enhancement Group®
810 Madison Avenue | Mankato, MN 56001
p. 952-249-6943 | [email protected]


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