Investing in Your HSA vs. Your 401(k)

Compare the tax benefits before you choose how to allocate your savings

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When you think about saving for retirement, you might think about employer-provided retirement plans like a 401(k) or 403(b). But your employer might also offer a health savings account, or HSA, which can not only help you save, but it can help you spend less in retirement too. Health savings accounts, as the name suggests, are intended to help pay for health-related expenses, and if utilized correctly, can provide you with a substantial source of value in retirement.

In this article we will look at what makes an HSA such a powerful retirement planning tool. 

Understanding Your 401(k)

To see what makes an HSA so useful, it’s helpful to understand the basics of how 401(k)s work.

401(k)s are a type of qualified retirement plan offered by your employer into which you can contribute a portion of your salary each year, up to a certain limit. For 2021 that limit is $19,500. If you are 50 or older, you can contribute an additional $6,500 “catch-up” contribution. If you have a traditional 401(k), you can deduct contributions from your income to avoid income taxes. The trade-off is that you’ll have to pay income tax on the withdrawals you make in retirement.

Money within your 401(k) grows on a tax-deferred basis until you withdraw it. 

Your employer may also match your contributions up to a certain percentage, and many employers do. The combination of your own elective deferrals and your employer’s matching contributions cannot be more than 100% of your salary, or $58,000, whichever is less. If you are eligible to make catch-up contributions then the total limit is $64,500.

What an HSA Can Do for Your Retirement

These HSA features make them a uniquely triple-tax free savings vehicle: 

  • Contributions to an HSA are deductible in the year you make them.
  • Any earnings on your account grow tax-free.
  • Withdrawals to pay for qualified medical expenses are also tax-free.

Like 401(k)s, health savings accounts allow you to save on a pre-tax basis. However, you must be enrolled in a high deductible health plan to qualify to contribute to an HSA. A high deductible health plan is just what it sounds like: It’s a traditional health insurance plan with a relatively high deductible that must be met before the plan pays benefits for anything other than in-network preventive care services. 

But unlike 401(k)s, withdrawals taken from your HSA are tax-free when used to pay for qualified medical expenses. IRS Publication 502 provides a partial list of qualified expenses, which includes things like dental treatment, eye exams, and hearing aids. 

If you take a withdrawal for any reason other than to pay for (or reimburse) medical expenses, you’d have to pay income tax on the distribution plus a 20% penalty (unless you’re disabled or at least 65 years old).

Also like 401(k)s, HSAs have annual limits on how much you can contribute, though they are much lower. For 2021, individuals with self-only coverage under a high deductible health plan can contribute $3,600. An individual with family coverage under a high deductible health plan can contribute up to $7,200. Your employer can contribute as well, but any employer contributions count toward meeting your annual contribution limits.

If you don’t use the entire balance of your HSA during the year then you can simply let that money roll over into the next year and accumulate.

How to Maximize HSA Savings

So how can you best use your HSA for retirement savings

  1. Contribute to your HSA.
  2. Don’t take withdrawals from it (so the balance can accumulate). 
  3. Once you retire, use HSA funds to pay for qualified medical expenses.
  4. Keep good records of all qualified medical expenses you incur prior to retirement, to claim during retirement.

The first three steps are simple enough, and effective. But with some planning and a little recordkeeping, you can make it even better. The key to getting the most out of your HSA is knowing that there is no time limit for when you can claim medical expenses.

According to the IRS, “An account beneficiary may defer to later taxable years distributions from HSAs to pay or reimburse qualified medical expenses incurred in the current year as long as the expenses were incurred after the HSA was established.”

In other words, once you open an HSA, any qualified medical expenses can be claimed at any time, even years into the future. With good records, the amount of qualified medical expenses you incur now and going forward, can be withdrawn tax-free from your HSA in retirement. Since that money is reimbursing qualified expenses you already paid for, you can use it for whatever you want.

For example, suppose you are 40 and have a $3,000 eye surgery that qualifies for a tax-free distribution from your HSA. If you maintain records verifying the amount of the surgery, you can withdraw that $3,000 any time—whether you’re 40, 50, 60, or any other age, as long as you established the HSA prior to the procedure, and the procedure wasn’t otherwise reimbursed.

Once you reach 65, you’ll no longer be subject to the 20% penalty on withdrawals taken for non-qualified expenses.

HSA vs. 401(k): Where Should You Put Your Money?

So which should you choose, a 401(k) or an HSA? Fortunately, you don’t have to choose, you can save in both. Consider the following when determining how to allocate your savings to each plan:

  • If you need easy access to savings specifically for medical expenses, then saving in an HSA should be a priority. 401(k)s may allow hardship withdrawals to pay for some medical expenses, but the rules are much more stringent and income taxes apply.
  • If you’re in a position to max out your retirement contributions, saving in both plans is a no-brainer. But if you only max your HSA each year, it would likely be inadequate to fully fund your retirement. So, you’d want to supplement it with a 401(k) which has significantly higher contribution limits.
  • If you only have one available to you, choose that. Not everyone qualifies to contribute to an HSA, and you may not work for an employer that provides a 401(k).