How HSAs Owners Could Have Avoided Retirement-Plan Penalties

Some people who borrowed or withdrew funds from their workplace retirement accounts in 2020 took out more than they needed, thereby unnecessarily paying additional taxes and depleting their balances. Some had another option.

A survey by Kiplinger and Personal Capital, a wealth-management firm, recently conducted a survey on employees who borrowed or withdrew funds from their workplace-based retirement accounts and Individual Retirement Arrangements (IRA). One-third of employees distributed funds from their accounts, and nearly half found that they borrowed or withdrew more than they needed.

It didn't have to be that way.

For these people, it's too late. Many ended up paying taxes and penalties on funds that they didn't need. And on funds that they did need.

But there was another way for some of them to pay medical bills with funds from a retirement plan without incurring taxes or penalties. If they'd only known. Here's some guidance for those who need resources to pay for qualified medical expenses in the future.

The Cost of Premature Withdrawals

Withdrawing funds early or borrowing from a workplace-based retirement presents a financial risk. A withdrawal before age 59 1/2, with limited exceptions, is included in taxable income and subject to a 10% penalty. There's an exception for medical expenses, but only to the extent that those expenses exceed 7.5% of taxable income. In other words, if your family income is $60,000, you avoid taxes and penalties for only those expenses that exceed $4,500. Thus, a family with $7,000 of qualified medical expenses not otherwise reimbursed couldn't withdraw more than $2,500 ($7,000 less $4,500) from an IRA without possibly incurring taxes and penalties.

A loan from a 401(k) plan is an option if the company's plan allows loans. And legislation last year increased the loan amount temporarily to as much as $100,000. But the loan must be repaid with interest. The interest is paid back into the account, making it in effect an interest-free loan. But people who took this option missed a market surge that started shortly after the stock-market plunge in March 2020, which would have boosted their balances much more than a negligible interest rate. And separation from the company often triggers prompt repayment, rather than continuing the traditional five-year repayment plan. Loans that aren't paid back by the due date are generally considered distributions, subject to income taxes and possible penalties.

The Health Savings Account Solution

One of the distinguishing features of a Health Savings Account is that balances can be used to pay today's or tomorrow's expenses, in sharp contrast to retirement accounts that are designed for long-term savings and investing. Owners who built balances in a Health Savings Account prior to the pandemic had a rainy-day fund from which to draw to cover their qualified medical expenses, thus freeing other sources of income (severance agreements, unemployment benefits, stimulus payments) to pay other living expenses.

According to the Devenir 2020 end-of-year Health Savings Account survey, the average balance in accounts opened five years earlier (in 2015) was $3,375. That's not a fortune, but for some families facing high medical expenses, it's $3,375 that they don't have to draw from other income or resources.

The IRA-to-Health Savings Account Rollover

For many people, there is a way to, in effect, take money from an IRA and use it to pay current medical expenses without incurring taxes or penalties. This strategy involves a one-time rollover from an IRA to a Health Savings Account.

Here's how it works:

• You're allowed a once-per-lifetime rollover.
• The funds must come from a single IRA. You may be able to consolidate if you have multiple IRAs or convert funds from another qualified retirement plan to an IRA.
• The rollover counts against contribution limits (which are $3,600 for self-only and $7,200 for family coverage in 2021).
• You must remain eligible to fund a Health Savings Account for 12 months after the month that you complete the rollover. Otherwise, the rollover is deemed a premature withdrawal from an IRA, subject to taxes and possibly penalties as well.

If you have an IRA or a 401(k) from an old employer that you can roll into a tax-deferred IRA, you can execute this strategy (and that old employer includes the company that just laid you off). But if you don't, there may be another way to fund the IRA to roll a balance into a Health Savings Account . . .

In-service Transfer

Many 401(k) plans allow participants who are age 59 1/2 or older to transfer a portion of their 401(k) balances to an IRA. It's a pretty simple process. You call your 401(k) administrator, review your plan documents, or speak to your company's benefits department to see whether your plan allows this transfer. If so, you can:

• Open a rollover IRA.
• Transfer funds into that account.
• Roll over a portion of the balance into a Health Savings Account.

That's it. Rather than taking the $2,500 in our example above from your IRA and incurring taxes and possible penalties, you can roll that amount (or any figure up to your statutory maximum annual contribution) from a 401(k) plan to an IRA, move it again from the IRA to a Health Savings Account, and then withdraw the $2,500 to pay your qualified expense tax-free.

This process may sound tedious - though it's not complicated. And it's probably worth it, as taxes and penalties often add up to between 40% and 50% of the distribution. In other words, to pay $2,500 of expenses from a Health Savings Account would require a withdrawal of $2,500. But you'd have to withdraw between $4,167 and $5,000 from your 401(k) plan to pay the same $2,500 plus the taxes and penalties.

But Be Careful

I don't recommend rolling over balances from a retirement account to a Health Savings Account to pay current expenses. If you do, you're spending an asset that you had set aside for you expenses much later in life. And depending on how far you are from retirement, removing $2,500 from your IRA now could cost you $10,000 of spending power in 18 years (assuming an 8% annual return) or $40,000 in 36 years.

As one CPA implored during a presentation nearly 15 years ago, "Don't eat the seed." I've never forgotten that term (obviously!), which drills home the point effectively. Hungry farmers who raid the sack of dried corn seeds in February plant less during the spring.

On the other hand, if you feel backed into a financial corner and your only option is to borrow or make a premature withdrawal from a retirement account to pay for qualified medical expenses, this strategy may save you thousands of dollars in taxes and penalties.

The Bottom Line

This strategy isn't to be taken lightly because it will reduce your retirement nest egg and turn an asset into an immediate expenditure. But if your retirement account is your only source of urgently needed funds, and you have a Health Savings Account, and you can move the retirement money into an IRA if you don't have a sufficient IRA balance, it's an option that minimizes taxes and penalties.

For that reason alone, it's worth knowing.

I'm director of strategy and compliance at Benefit Strategies, LLC, an administrator of Health Savings Accounts and reimbursement accounts. You can read and subscribe to my Health Savings Account GPS blog here and read my weekly HSA Monday Mythbuster and HSA Wednesday Wisdom columns and occasional Healthcare Update column published on LinkedIn. My book, HSAs: The Tax-Perfect Retirement Account, is the definitive guide to navigating the intersection of Health Savings Accounts, retirement planning, and Medicare. It's available in paperback and e-book at Amazon.

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