Tax Strategies for IRAs & HSAs at Retirement

retired coupleHere’s a strategy to tackle two challenges facing many retirees: rising medical costs and paying taxes on IRA withdrawals.

Typically, withdrawals from traditional IRAs are considered taxable income. But if you’re between the ages of 59-1/2 and 65 (or whenever you enroll in Medicare), you can take a withdrawal from a traditional IRA account and make a corresponding Health Savings Account (HSA) contribution that will offset it, as long as they are both done within the same year.

By using the cash from a traditional IRA to fund the HSA contribution, you are shifting tax-infested traditional IRA assets to more tax-friendly HSA assets that can be used tax free for qualified medical expenses.

Here’s an example of how this can be implemented. Joe turned 59-1/2 on July 1, 2016, and is also participating in a high-deductible health plan (HDHP) that allows him to make contributions to an HSA. He can take a distribution before December 31, 2016, from his traditional IRA to make a contribution in the same amount to an HSA by April 17, 2017. Joe can transfer an amount up to the maximum HSA contribution for that year. In 2016, the contribution amount for a single plan was $4,350 ($3,350 plus a $1,000 catch-up for being age 55 or older), and 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 65, he could make 6-1/2 years of contributions. He only gets to contribute half during the year he turns 65, assuming he enrolls in Medicare on July 1. If the contribution amounts stay the same over that period, it comes to $28,275 on a single plan, or $50,375 on a family plan. That results in significant tax savings, considering that otherwise these withdrawals would be taxed as ordinary income! 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.

After age 65, if HSA distributions are not used for qualified medical expenses, taxes must be paid on them. However, no minimum distributions are required for HSAs, as they are for traditional IRAs. This makes HSAs inherently superior. With rising health costs, most people will not have trouble finding qualified expenses for tax-free withdrawals.

For those under age 59-1/2, this strategy is not as effective because withdrawals from traditional IRAs are subject to a 10 percent penalty. However, making a “once per lifetime” transfer from a traditional IRA to an HSA can be an effective solution. Those under age 59-1/2 might be best served by funding HSA accounts in lieu of traditional IRA or other tax-deferred retirement accounts in order to build up more tax-favored funds 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!

Here’s one last spin on this strategy. If Joe leaves a company where he has a 401(k) plan in the year he turns 55 or older, he can take withdrawals from his 401(k) plan without the 10 percent penalty in order to fund HSA contributions. The downside is that the 401(k) withdrawals are subject to 20 percent 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 percent withholding. 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.