401k or HSA — How to Balance Your Contributions to Both
By now many of us have heard of a Health Savings Account, or HSA. Further, most High Deductible Health Plans (HDHPs) participants — a qualification to contribute to an HSA — appreciate their HSA works much like a health Flexible Spending Account (FSA). However, a new savings strategy is starting to develop and be recommended by financial planners and retirement services firms. That strategy is to use your HSA as a complement to your existing retirement savings program, such as your 401(k).
But where does this new HSA strategy leave the trusted 401(k) retirement savings plan we’ve been talking about for years? And, assuming you don’t have enough money to maximize contributions to both (over $20,000 a year, for most), how do you choose?
Everyone is Different
While these are fundamental questions to be thinking about as you plan your financial future, it is also important to understand everyone’s financial situation is different. Financial planners know this, of course, which is why after they review all your information they switch gears and talk about your attitude towards money, retirement, health, and financial security, as well as what you hope to achieve in life. Like snowflakes, we are all unique.
However, and just as we have in our mobile app here at HSA Coach, below we provide a framework for balancing these two very common, tax-advantaged savings accounts. The terminology, not to mention the tax code, can often be confusing, but the general guidance and saving philosphy need not be.
Three Steps for the Most (Tax) Savings
Step 1. Find out your employer’s 401(k) contribution match, and fund your contributions to maximize these “free” match dollars. Employers like to encourage employees to contribute to their retirement savings plans, and to do this they often offer to match employee contributions. This is free money to you, the employee. All you have to do is contribute up to the employer match levels.
The importance of obtaining this free money cannot be overstated. No tax code statute I’m aware of (save certain refundable tax credits) offers a better return than free money. So if you don’t already know, find out what your employer’s retirement plan contribution specifics are and invest that amount to maximize your employer’s match contribution.
Step 2. Fund your HSA to the maximum amount your budget allows. If you followed Step 1, you are receiving free money from your employer as a result of your pre-tax savings contributions. Now you need to look to the tax code to understand why this second step works. An HSA is a tax-free savings vehicle (when used for qualified medical expenses, and a similarly whereas a 401(k) is a tax-deferred savings vehicle when used for non-medical retirement purposes.
I’ll explain briefly here.
Similar to 401(k) contributions, HSA contributions are excluded from taxable income. However, when you withdraw 401(k) funds in retirement, the IRS taxes those amounts as though ordinary income (i.e. you lose favorable capital gains tax treatment). However, when funds are withdrawan from HSAs for qualified medical expenses, such amounts, including any growth in the account through interest or capital appreciation, are tax-free. No ordinary income tax is assessed.
In the event you elect to spend HSA withdrawals on things other than qualified medical expenses, the tax code will charge you ordinary income tax, the same as your 401(k). In this situation both the 401(k) and HSA offered equivalent tax deferred growth. Finally, contributions to HSAs are excluded from payroll tax calculations, so for most there is an additional 7.65% savings results the moment you deposit those funds into the HSA account. Many in the industry refer to HSAs as offering “triple tax savings.”
Step 3. Contribute to your employer’s 401(k) above the match limit to the maximum allowed (see plan year guidance). If you followed Steps 1 and 2, you’ve maximized both your employer-provided free match money as well as the favorable tax-free features of your HSA. Now you should return to contributing to your employer’s 401(k) to maximize the advantages of tax-deferred savings.
For reference, below are some of the similarities and differences between 401(k) s and HSAs.
1. Before tax contributions to both. Note HSAs are also pre-payroll tax, often another 7.65% of tax savings.
2. Balances grow tax deferred.
3. Penalty applies for early withdrawals. For 401(k)s this penalty applies to withdrawals before age 59 ½, though there are many exceptions. For HSAs this penalty applies to non-health expense qualified withdrawals before the age of 65.
4. Both 401(k) and HSA accounts offer catch up contributions for participants over age 50 and 55, respectively.
1. HSA funds can be used at any time for qualified health expenses. Withdrawals, both deposits and any account growth, are tax-free.
2. HSA eligibility is conditioned upon participation in a HDHP.
3. Contribution limits are different. Maximum HSA contribution limits are much smaller than 401(k) ceilings.
4. 401(k)s offer loans withdrawals. Not all plans, and there are limitations. Check with your employer for plan specifics.
Short-Term Savings OK
Finally, this discussion focused on the long-term savings component of HSAs and the comparative tax advantages of an HSA savings technique to the more familiar 401(k) retirement savings plan. However, today HSA accounts are primarily used like FSAs to cover immediate health expenses. As discussed in previous articles and referenced at the start of this article, HSA eligibility is a function of HDHP participation. Although this can result in higher out of pocket medical expenses and higher plan deductibles than traditional health insurance plans, there are often significant monthly savings. For certain participants these bi-weekly payroll savings outweigh the higher out of pocket and deductible costs.
Nevertheless, for many consumers it makes sense to keep at least a portion of your HSA contributions in cash or debit accounts for ready access to pay for periodic health expenses. Most HSA providers require a minimum balance in such debit accounts before accessing the long-term growth options in brokerage accounts, so often this funding split between short-term savings is decided by the mechanics of the plan.
Below are a few posts on open enrollment:
Below are a few posts on health:
And here are some reviews of popular book titles in the health space:
· Dr. Eric Topol’s “The Patient Will See You Now: The Future of Medicine is in Your Hands” here.
· Athenahealth Co-Founder and CEO, Jonathan Bush, “Where Does It Hurt: An Entrepreneur’s Guide to Fixing Health Care” here.
· Dr. Marty Makary’s “Unaccountable: What Hospitals Won’t Tell You and How Transparency Can Revolutionize Healthcare” here.