Turn unused sick and vacation pay into tax-free retiree medical money.
Cities, townships, counties, school districts and authorities owe their retirees two things that are hard to fund: the leave balances employees have banked over a career, and a way to pay for health coverage in the years before Medicare. A retiree health reimbursement arrangement connects the two, and done correctly the money never passes through payroll tax. See school district employee benefits and public employer benefits.
We design and place the arrangement and coordinate it with the retiree medical plan you already offer, so the two work as one benefit rather than two separate promises.
Leave the employer already owes becomes a medical account the retiree controls.
| Step | What Happens |
|---|---|
| Conversion | At retirement, and in some designs each year, the plan converts a set share of unused sick and vacation leave by a formula the employer chooses. The employee does not choose. |
| Deposit | The converted amount is credited to a health reimbursement account in the retiree’s name. |
| Reimbursement | The retiree is reimbursed for eligible medical expenses and health premiums for themselves, a spouse and dependents — including Medicare premiums after 65. |
| Carryover | Unused balances carry over from year to year for as long as the retiree or covered family members are living. |
| Forfeiture | Once the retiree and covered family members have died, any remaining balance is forfeited. It is never paid out as cash. |
Three places the money is not taxed.
Paid out as a lump sum at retirement, banked leave is ordinary wages. Converted under a qualifying plan, it is not.
Going In
Converted leave avoids the 7.65% employer share and the 7.65% employee share of FICA wherever FICA applies, and it is not income to the employee. Leave conversion delivers payroll tax savings for public employers and a tax-free health benefit for employees.
Coming Out
Reimbursements for eligible medical expenses and premiums are not taxable to the retiree, so every dollar converted is worth a full dollar of care. Tax-free reimbursements make every converted dollar count. That is why converted leave is worth more in the account than as a lump-sum payout.
The Bridge
The account pays for coverage in the years between retirement and Medicare, when retiree premiums are highest, and then helps with Medicare premiums after. A retiree HRA bridges the gap to Medicare. It then helps with Medicare premiums after age 65.
The tax treatment depends on four design choices, and all four are easy to get wrong.
No Cash Option
The conversion has to be mandatory under the plan. If employees can choose cash instead of the account, the tax exclusion is lost. Mandatory conversion protects the tax exclusion. If employees can choose cash instead, the exclusion is lost for the whole group.
The Employer Sets the Formula
The IRS has approved converting leave accrued before the plan started, annual leave that would otherwise be forfeited, and leave unused at retirement, in amounts the employer alone decides. Employer-set formulas keep retiree HRAs compliant. The employer alone decides the conversion amounts.
No Payout to Heirs
Balances can follow a surviving spouse and dependents, but paying what is left to a beneficiary as cash breaks the tax treatment for the arrangement. No cash payout to heirs protects the retiree HRA’s tax status. Balances follow surviving family instead.
Bargaining Comes First
For represented workforces the conversion formula is usually a bargaining item. The design has to be uniform for the covered group and settled before the plan document is signed. Bargaining comes before the retiree HRA plan document. Settle it before signing.
See what federal benefits penalties cost when a plan is designed wrong →
Where this fits under Public Act 202.
Michigan’s Protecting Local Government Retirement and Benefits Act treats a local retiree health plan as underfunded when it is less than 40% funded and its contributions exceed 12% of the unit’s operating revenues. Underfunded units work out a corrective action plan with the state’s Municipal Stability Board, and every unit offering retiree health must at least pay the annual retiree premiums and, for new hires since 2018, the full normal cost.
A retiree HRA does not change a liability that already exists. What it can do for future retirees is replace an open-ended promise with a defined amount funded from leave the employer already owes. How that is reported is for your actuary and auditor; how it is designed is where we come in. School districts should also read our explainer on MESSA, and anyone with retirees approaching Medicare should read how Medicare maximization works.
What finance directors and HR ask first.
Ten answers for the people who will have to explain it to a board.
What is a retiree HRA?
An employer-funded account that reimburses retirees for eligible medical expenses and health premiums, for themselves, a spouse and dependents, tax-free. For public employers it is often funded by converting unused sick and vacation leave. Retiree HRAs turn unused leave into tax-free health dollars.
Can we convert unused sick leave into an HRA?
Yes, under IRS guidance, as long as the conversion is mandatory under the plan and the employer sets the amount. Leave accrued before the plan began, annual leave that would otherwise be lost, and leave unused at retirement can all qualify.
Can employees choose between cash and the HRA?
No. That choice is exactly what makes the converted amount taxable. The plan has to decide how leave is converted, and the employee cannot elect cash instead. Mandatory conversion keeps retiree HRA funds tax-free. The plan decides how leave is converted, not the employee.
How much payroll tax does it save?
On the converted amount, the 7.65% employer share and the 7.65% employee share of FICA wherever FICA applies, plus the employee’s income tax on what would otherwise have been a lump-sum payout. Retiree HRAs save both employer and employee payroll taxes.
What can retirees use the money for?
Eligible medical expenses and health insurance premiums, including retiree medical premiums and Medicare premiums, for the retiree, a spouse and dependents. Retiree HRAs cover medical expenses and premiums, including Medicare premiums after age 65. Coverage extends to a spouse and dependents.
What happens to the balance when a retiree dies?
A surviving spouse and dependents can keep using it. Once there is no one left to cover, the balance is forfeited. It cannot be paid to heirs as cash. Retiree HRA balances support surviving family members. Balances cannot be paid to heirs as cash.
Does this replace our retiree medical plan?
No. It works alongside it, and retirees often use the account to pay their share of the retiree medical premium until Medicare. Retiree HRAs complement retiree medical plans. Retirees often use the account to pay their share of the retiree medical premium until Medicare.
Is this only for public employers?
The IRS structure is available to any employer. It is most common in the public sector, where large banked leave balances and retiree health promises are both the norm. Retiree HRAs are most common in the public sector, but any employer can offer one.
Do union contracts affect how it works?
Usually. The conversion formula is often negotiated, and the plan has to apply it uniformly to the covered group once it is agreed. Bargained formulas must apply uniformly. Once agreed, the conversion formula has to apply to every member of the covered group.
Does a retiree HRA help with Public Act 202?
Not with a liability you already carry. For future retirees it can replace an open-ended retiree health promise with a defined amount, and your actuary and auditor decide how that is reflected in reporting. Retiree HRAs can define future retiree health promises.
Want to see what a conversion formula would look like for your unit? Send us your current plan, or talk it through with someone first. No cost, no obligation.
Figures and rules read at the source in September 2026. General information, not legal or tax advice; plan design and reporting questions belong with counsel and your actuary, and we will bring counsel in.
Where the Rules Come From.
The laws and rules named on this page link to the statute or regulation they come from. This is general information, not legal or tax advice, and rules change, so check the current text.
COBRA Continuation Coverage (29 U.S.C. 1161)
Requires many group health plans to offer temporary continuation coverage after a qualifying event.
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