Ask Penny: Should I Contribute to My HSA or My 401(k) for Retirement Savings?
November 27, 2018
Open enrollment season is here and employees electing a high-deductible health plan (HDHP) with a health savings account (HSA) must decide how much to contribute to their HSA for 2019. What’s a good recommendation? Employees should prioritize their HSA ahead of their 401(k), maxing out their HSA contributions if possible. Here’s why:
HSAs have triple tax benefits. If you contribute to your HSA through payroll deduction, those funds are deducted from your pay before federal (and, typically, state and local taxes) are withheld. Unlike pre-tax 401(k) contributions, HSA contributions made from payroll deductions are truly pre-tax. Medicare and Social Security taxes are not withheld. This reduces your taxable income and, therefore, the amount you pay in taxes. When HSA funds are used to pay qualified healthcare expenses, the money comes out tax-free. Also, the money in your HSA grows tax-free; you don’t have to pay taxes on the interest or investment earnings on the funds in your account. No other employee benefits currently work this way.
If you don’t use it, you won’t lose it. HSAs can be confused with flexible spending accounts (FSAs), for which balances not used by the end of the year are forfeited. With HSAs, unused balances carry over to the next year indefinitely and balances are never forfeited due to lack of use.
Contribution limits. Maximum annual HSA contribution limits (employer plus employee) for 2019 are $3,500 per individual and $7,000 for a family. An additional $1,000 in catch-up contributions is permitted for those age 55 and older.
Covering retiree healthcare expenses. Accumulated HSA balances carried over into retirement can be used to pay for many routine and non-routine healthcare expenses such as Medicare premiums, long-term care insurance premiums, COBRA premiums, prescription drugs, dental expenses and any co-pays, deductibles or co-insurance amounts for you or your spouse. HSA accounts are a tax-efficient way of paying for healthcare expenses in retirement, especially if the alternative is taking a taxable 401(k) or IRA distribution. Once you reach age 65, you can use HSA funds for any purpose without incurring a penalty. It's important to remember, however, that if you use HSA funds for something other than a qualified health expense those funds will be taxed as income
No minimum distribution requirements by age. There are no requirements to take minimum distributions at age 70.5 from HSA accounts as there are on 401(k) and IRA accounts. Any unused balance at your death can be passed on to your spouse if you have completed a beneficiary designation. After your death, your spouse can enjoy the same tax-free use of your account. (Non-spouse beneficiaries lose all tax-free benefits of HSAs).
HSAs and retirement planning. While HSAs are a good way to cover immediate health care costs, they can also be used to save and invest money for the future. The number of people using their HSA as an investment tool is growing rapidly. If you want to use your HSA to save money, contribute more funds to the account than you need to cover your yearly health care expenses and let the money accrue tax-deferred. Some HSAs allow you to invest in mutual funds just like you'd contribute to a 401(k) or an IRA.
HSA or 401(k)? The following contribution strategy incorporating HSA and 401(k) accounts would benefit most people when planning for retirement:
1. Make the maximum allowable yearly contribution to your HSA account via payroll deduction. Besides being triple tax-free and not being subject to required minimum distributions, these account balances are often used every year for family healthcare expenses.
2. Calculate the percentage that allows you to receive the maximum company match in your 401(k) plan and contribute at least that percentage each year.
3. If you can contribute more, calculate what it would take to max out contributions to your 401(k) plan by making either the maximum percentage contribution or reaching the annual limit.
4. If you are still able to contribute and are eligible, consider contributing to a Roth IRA. Roth IRAs have no age 70.5 minimum distribution requirements, unlike pre-tax IRAs and 401(k) accounts, and account balances may be withdrawn tax-free under certain conditions.
Calculate each contribution above separately and then determine what you can commit to for the year. Build an HSA balance that carries over into retirement by maxing out you HSA contributions each year and investing unused contributions so account balances grow.
If you're unsure about whether you're ready to use your HSA as an investment tool, talk to a tax professional or investment adviser who is well-versed in HSAs.