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How to Move Funds From Your HSA to Your Roth IRA

Over the course of the nearly 20 years that they've been in existence, health savings accounts (HSAs) have become very popular in the personal finance community and for very good reason. Participants can make tax-free contributions, funds in the HSA can be invested and grow tax-free, and tax-free withdrawals can be made at any time for qualified medical expenses. No other type of account offers this 'triple tax-advantage'. And for this reason, after obtaining the maximum match from an employer-sponsored retirement plan like a 401(k), an HSA should virtually always be the first tax-advantaged account that you max out.

In order to give their investments inside an HSA maximum time to grow, many pay for qualified medical expenses out of pocket and retain the receipts (or explanation of benefits), planning to reimburse themselves from the HSA at some point in the future.

That's not a bad plan at all. But for many, there is an even better one: swap HSA funds for Roth IRA funds. Below, I explain why this is worthwhile and how to do it.

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There are two drawbacks with HSAs. First, while withdrawals after age 65 can be made for any reason, if they are for anything other than qualified medical expenses, they are taxable income. Second, when someone other than a spouse inherits an HSA, the entire account balance is taxable income for that person that calendar year.

Compare this to the Roth IRA. After age 59.5, tax-free withdrawals can be made for any reason, there are no required minimum distributions, and the account is passed on tax-free to non-spousal heirs, who have 10 years to withdraw the balance. In these respects, the Roth IRA is decidedly superior to the HSA.

So, can you swap funds in an HSA for funds in a Roth IRA?

Yes, you can, but this requires that you have tax-deferred funds that could be converted to a Roth IRA (e.g., non-deductible IRA, traditional IRA, a 401(k) or 403(b) from a prior employer or one that allows for in-service withdrawals).

With such funds in place, swapping money in an HSA for a Roth IRA is simple. When you have qualified medical expenses, withdraw the funds from your HSA, and do a Roth conversion of the same amount.

This allows you to take advantage of tax-free contributions to the HSA, but by doing a Roth conversion rather than paying for qualified medical expenses out of pocket, you effectively swap funds in the HSA for the Roth IRA, which is better both for you (i.e., tax-free withdrawals for any reason after age 59.5) and your heirs (i.e., who pay no taxes on the Roth IRA and can retain it for up to 10 years after your passing).

Also, you should consider whether the Roth conversion will push you into a higher tax bracket. If it will, then it may not be worthwhile to do the conversion.

Note that you still need to keep receipts for at least three years after withdrawing from the HSA in the event that the IRS audits you and wants proof that the withdrawals were for qualified medical expenses. You don't have to keep paper receipts, and this can actually be bad idea since the thermal paper that many receipts are printed upon can degrade. Instead of keeping paper, simply scan receipts and save them in a secure location with other tax documents.

If you get an explanation of benefits (EoB) for qualified medical expenses, scan it too. If the IRS comes knocking, you will need to show specifically which goods and services you paid for and when. Year-end summaries and the like will not be acceptable if they do not show this level of detail.

While this strategy only allows you to swap HSA funds for Roth IRA funds in an amount equal to your qualified medical expenses, these can (unfortunately) be quite significant over time, and the advantage of Roth IRAs over HSAs both for you and your heirs is substantial.

Bonus tip: If you are wanting to leave behind a portion of your assets to charity upon your passing, then it's wise to make a charity the beneficiary of your HSA (or secondary beneficiary, if you're married). This is due to the poor tax treatment of HSAs for non-spousal heirs. The charity will receive the funds from your HSA with no taxes, and your heirs will do better inheriting other assets.

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