Should I Fund an HSA from a Roth or Traditional IRA?
I got a message through my website recently from a YouTube viewer named Ricky, inquiring about contributions to an HSA in the years between retirement and Medicare at age 65.
I’m 59, retired this year with an HSA and will contribute the max until 65 each year. Which is better, to fund the HSA from a Roth IRA or Traditional IRA?
Before I answer Ricky’s question, I want to highlight that from here on out I’ll be operating under the assumption that Ricky or any other hypothetical HSA users I discuss are actually eligible to make contributions to an HSA.
For a basic, nuts and bolts primer on HSA eligibility, contribution limits, tax strategies, etc., please check out our video or blog post that explains most general information you need to know about HSAs.
Now, since I don’t like to prolong things, I’ll get right to the answer.
The best place to make contributions to an HSA is from earned income.
Specifically, it’s even better if you can make contributions to a plan at work through income deferrals because it shelters those contributions from Social Security and Medicare taxes too. That’s another 7.65% of tax savings on your contributions.
If you can’t make contributions through income deferrals, opening an HSA on your own and contributing money that isn’t in a tax-advantaged account will produce the greatest opportunity to snatch up tax savings on contributions, earnings, and withdrawals.
This includes money from taxable investment accounts that haven’t had and won’t ever have any other tax advantage available to them.
The reason fully taxable assets are best will be evident in the explanation below.
But that’s not the question Ricky asked.
Based on Ricky’s message, since he* is retired, I’m assuming Ricky doesn’t have any earned income or taxable assets available for HSA contributions. Ricky is choosing between Traditional and Roth IRA funds to optimize contributions.
(*Honestly, it wasn’t clear from Ricky’s message if he or she is male or female, married or single, so I’ve had to make some assumptions. If any of them are wrong, I apologize to you, Ricky.)
In this case, Traditional IRA funds would be better because Roth accounts are funded with contributions that have been subjected to income taxes that cannot be recaptured.
Traditional IRA contributions, on the other hand, aren’t taxed until you make withdrawals. And, in the case of withdrawals that will become HSA contributions, you can effectively preserve the tax-deferred benefits of your IRA contributions because the taxable income you realize from those withdrawals will be offset by deductible contributions to the HSA.
For more about these distinctions, please read on and I’ll walk through a hypothetical scenario to illustrate the benefits of using Traditional IRA funds over Roth.
Also, I’ll show why fully taxable funds are best and highlight an HSA/IRA strategy that I stumbled upon thanks in large part to Ricky’s question.
Contributions From Roth IRA
As usual, when I set out to respond to Ricky’s question, I started with a spreadsheet.
I was fully prepared to investigate the future value of Ricky’s HSA after seven years of contributions (made starting at age 59 and running through age 65) and any subsequent investment returns.
But that’s not really relevant to the question because the performance of the HSA contributions will be the same regardless of where the money comes from.
To identify the optimal source of contributions, we need to consider the impacts of tax benefits that are gained or lost by using IRAs.
Let’s start by analyzing the use of Roth IRA dollars.
The actual cost of using Roth dollars is a bit of a challenge to calculate, but it can be done if you know your tax rate when you made your contribution, the rate of return you have received from your contribution, and how long your contribution has been receiving that rate of return.
For the sake of our illustration, I’m going to have to make some assumptions that would be very challenging to ascertain in reality, but they should serve us well enough in a hypothetical scenario to make the point.
So, we’re going to assume that Ricky is considering using Roth dollars that were contributed 20 years ago, that those contributions have earned 7% annually since 2004, and that Ricky’s marginal tax rate has been 22% all these years.
Using all of these data points, we can discern that the $4,150 Ricky will withdraw to max out HSA contributions for a single person in 2024, would have required an after-tax contribution of $1,072.44 to Ricky’s Roth IRA way back in 2004.
If Ricky’s marginal tax rate back then was 22%, that means he needed $1,374.92 in pre-tax dollars to fund his Roth IRA for each $4,150 payoff 20 years down the road.
That’s $302.48 of tax deferrals that Ricky has passed on for each maximum contribution to his HSA 20 years later.
If Ricky makes seven contributions to his HSA between 2024 and 2030 (ages 59-65), that’s a total of $2,117.38 of taxes paid for Roth contributions that he cannot recover, even if he moves the money into the HSA.
But taxes aren’t the only cost Ricky will pay.
Since we’re evaluating the use of Roth vs Traditional funds, we should also consider the value of that $2117.38 if Ricky was able to invest it for 20 years instead of paying it out in taxes.
The opportunity cost of $2117.38 at the same 7% rate of return over the course of 20 years is $8,193.59.
If you ask me, this is the true lost value of using Roth IRA dollars to fund an HSA. It’s not just the tax inefficiency, it’s the opportunity cost of not being able to invest that money as well.
(I know Ricky’s contributions and withdrawals will not occur in the same year or at the same rates of compounding over time, but again, this is a hypothetical example. The math would check out even if I confused the issue more by complicating contribution and withdrawal rates. I’ll continue using the same assumptions as we look at using the Traditional IRA.)
Contributions From Traditional IRA
Now let’s look at using the Traditional IRA as a source for funding the HSA instead.
The good news is I don’t need to reset the stage of assumptions here on our math. We’ll use the same investment period, tax rates, and rates of return for an apples-to-apples comparison.
For a $4,150 HSA contribution in today’s dollars, Ricky would have needed to contribute the same amount, $1,072.44 to his Traditional IRA way back in 2004.
The key difference this time is that Ricky’s contributions to the Traditional IRA would have been made on a tax-deferred basis, meaning he would have avoided $302.48 in taxes for each $1,072.44 he saved for his future HSA.
With seven years of future HSA contributions, that’s the same $2,117.38 of taxes lost by using the Roth.
Now, you may be asking yourself, “But won’t Ricky owe income tax on the withdrawals from his Traditional IRA?”
Yes. Yes, he will.
However, Ricky’s contribution to the HSA will also receive a tax deduction, offsetting the income taxes from the IRA distribution.
In effect, by using a Traditional IRA to fund his HSA, Ricky has used a tax-deferred investment to prefund his HSA years in advance.
And, looking at the question this way inspired an idea for IRA tax efficiency that I want to come back to in just a minute.
But first, I want to explain why using fully taxable dollars is the best way to fund an HSA.
Contributions from Cash or Income
Based on what we’ve seen so far, using a Traditional IRA to fund HSA contributions is far superior to using a Roth.
However, I still don’t love the idea of using a Traditional IRA to fund an HSA because it means you’re basically substituting an opportunity to invest money on a tax-deferred basis with money that would have received a tax deduction when you put it into the HSA anyway.
For example, in 2024 if you are under 50 you can contribute up to $7,000 to an IRA.
If you earmark $1,072.44 of that contribution for future HSA use, then you’re surrendering that same amount in tax-advantaged investing space because you’ll use both the IRA and the HSA deductions for the same dollars.
Of course, this assumes that you will max out contributions to tax-advantaged accounts like IRAs and 401(k)s. If you’re not going to do that anyway, then it’s a moot point.
And that brings me back to the potential tax strategy I stumbled upon while researching this.
Using HSA Contributions to Reduce Your RMDs
I don’t want to oversell this like I’ve discovered the HSA equivalent of the mega-backdoor Roth, but it could be a useful strategy, nevertheless.
If you have saved well in tax-deferred accounts over the years and are approaching retirement with large balances that will be subject to Required Minimum Distributions, then using Traditional IRA dollars to fund HSA contributions could be an effective way to reduce this future tax liability.
We’ve already illustrated how using a Traditional IRA to fund an HSA is effectively a tax-free transaction, but it could also reduce your IRA balance by $4,150 in 2024 if you are single and $8,300 if you are married.
Again, you’ll need to be eligible for contributions to an HSA to do this and if your IRA balances are in the millions, this will be a drop in the bucket.
But, if you’re like me, every drop saved from taxes is worthwhile, so this could be worth keeping in mind.
You should also remember that HSAs transfer to a surviving spouse tax-free, but the balance is fully taxable in the year it is inherited by any other beneficiaries.
At least if the money is inherited in an IRA, your non-spouse beneficiaries can distribute the balance over 10 years which could save them quite a bit in taxes.
Keep this in mind if your HSA balance is getting too large for you to use in your lifetime.
Wrap Up
So, in summary, it’s best to use earned income first to fund your HSA. If that’s not an option, use dollars that are fully taxable to capture the full value of available deductions.
Finally, if you’re choosing between using Roth or Traditional IRA dollars, use the Traditional IRA funds first so you can avoid surrendering the benefit you gained by prepaying taxes on Roth contributions years earlier.
Thanks for reading!
