Nearly every retirement article you read suggests that you should contribute every penny you can spare into your 401(k). Generally speaking, that’s pretty good advice. However, if you have access to a Health Savings Account (HSA), you may want to rethink that advice. Before I can explain, let me first outline the features of a traditional 401(k) a Roth 401(k) and an HSA.
A traditional 401(k) allows for pretax deferrals, which reduces your taxable income and the income tax due in that year. While federal income tax is avoided, FICA taxes (Social Security and Medicare) are still assessed on the contribution amount. In 2019, the maximum you can defer into a 401(k) plan is $19,000, unless you are at least age 50, when you can defer an additional $6,000 for a total of $25,000 a year.
As the investments grow, no tax is due on any gain until you withdraw money from the plan. At that time, you will pay ordinary income tax on all withdrawals (plus a 10% federal penalty if you are not at least 59½, or in the event of a few other less-common situations). You make pretax deferrals but receive taxable distributions.
A Roth 401(k), provides that deferrals be made with after tax dollars. This means that you will not save any income taxes at the time of the contribution. The maximum limits for a Roth IRA are the same as a traditional 401(k). Similar to the traditional 401(k) option, the investments grow free of taxation. However, all qualified distributions from a Roth 401(k) are income tax-free. Qualified distributions are those in which the account is at least five years old and the distribution is made due to disability, death or upon reaching age 59½. So, your contributions are taxable but your distributions are generally income tax-free.
The HSA was established under the Medicare Modernization Act of 2003 and was created to allow a participant the ability to pay medical expenses with pretax dollars. In order to be eligible for an HSA, you must first be enrolled in a qualified High Deductible Health Plan (HDHP). In order for a plan to qualify as a HDHP, it must require a deductible of at least $1,350 for self-only HDHP coverage or $2,700 for family HDHP coverage and a maximum out of pocket expense (deductibles, copayments and other amounts, but not premiums) of no more than $6,750 for self-only plans and $13,500 for family plans. Not all HDHPs are HSA eligible, so you should check with your insurance carrier to make sure your plan qualifies.
If you qualify to participate in an HSA in 2019, you can contribute up to $3,500 if you have a self-only deductible or $7000 if you have a family deductible. You can contribute another $1000 on top of those amounts if you are at least age 55 during any time of the year.
HSA contributions are federally tax-deductible. Even better, any contributions made through a Section 125 payroll deduction plan also escape FICA (Social Security and Medicare) taxes. This can save an additional 7.65% tax on the amount contributed. If your employer makes contributions on your behalf, those contributions are also tax-free, but the combined contribution is still limited to the annual maximums previously mentioned. You can contribute to an HSA regardless of your income (in fact, you don’t have to have any income to contribute), but you lose eligibility to contribute once you enroll in Medicare (generally age 65). While you may not be able to contribute any longer, you can still keep your plan for distributions. HSA plans are completely portable. You can take them with you when you change employers or when you retire.
Qualified distributions from an HSA are income tax-free for the owner and the owner’s spouse or dependents. In order for the distributions qualify for tax-free status, they must be used for qualified medical expenses, which include medical, dental, vision, and chiropractic expenses. Additionally, once the owner reaches age 65, qualified expenses also include premiums for Medicare (but not Medigap), employer provided health insurance, COBRA, and long-term care Insurance. Distributions that do not meet this criterion, are subject to federal income taxation plus a 20% penalty. However, once the owner reaches age 65, the 20% does not apply. HSA plans do hot have Required Minimum Distributions (RMDs). You are never required to take distributions from the plan regardless of your age. It is important to understand that this discussion relates to federal income taxation only. Each state has laws that govern state taxation of contributions and distributions.
HSA plans can be rolled over from one spouse to the other without taxation. If the participant dies, the spouse can take the plan over as his or her own and use the funds as if he or she is the original owner. However, if the HSA is left to anyone other than a spouse, the funds become taxable immediately in the year of death. There is no “stretch” provision to allow the beneficiaries to take small distributions over their life expectancies. Also, non-spouse beneficiaries cannot use the account for their own medical expenses on a tax-favored basis.
One of the largest expenses that most of us will face in retirement is medical costs and premiums. According to the Employee Benefit Research Institute (EBRI), a couple retiring today would need $286,000 to have a 75% chance of funding medical expenses and premiums during retirement—that is over $140,000 per person. No matter what size your nest egg is in retirement, $140,000 takes up a pretty large portion of it. So, if we know that we will have significant medical expenses in retirement, we should make certain we prepare for these expenses.
While a 401(k) is a very good vehicle to grow your retirement funds, it is a terrible vehicle for distributing those funds. If, for example, your effective tax rate is 15%, then for every dollar you need in retirement, you will need to withdraw $1.18 to net out that dollar ($1/ (1-.15) = $1.18). So, in order to spend $140,000 in retirement for medical expense, you would need to have nearly $165,000 set aside. The Roth 401(k) does not have the distribution taxation problem, but it does not provide the tax deduction up front.
Consider saving enough in your HSA to both pay for current medical expenses each year and to save for medical expenses in retirement. You will not need to waste valuable 401(k) retirement resources on taxes upon qualified distributions at retirement and you will not lose the tax deduction on your contribution like you would using a Roth 401(k).
Let’s assume a 35-year-old individual makes $65,000 a year and is contributing 10%, or $6,500 a year, of pay divided equally between a traditional 401(k) plan and a Roth 401(k) plan, ($3,250 each). This employee wants to incorporate the HSA into the retirement strategy to provide tax advantaged dollars toward medical expenses in retirement. In order to have $140,000 available for medical expenses at age 65, the participant would have to commit in $2,006 a year into the HSA in addition to the current estimated annual medical costs. (This calculation assumes the HSA plan earns 5% each year which, of course, is not guaranteed.) The remaining $4,493 would be allocated as follows: $3,250 to the Roth 401(k) (the amount currently being contributed) and $1,243 to the traditional 401(k). As the employee’s income grows, simply allocate the incremental increases evenly between the traditional and Roth 401(k) plans and keep the HSA payment level.
This plan provides the most tax advantageous way of funding medical expenses at retirement without sacrificing future retirement savings or current income tax savings. Assuming all of the accounts earn the same rate of return, the HSA will provide the most efficient method to pay for medical expenses at retirement since it provides both tax deductible contributions and tax-free distributions for qualified medical expenses. And if the full balance in the HSA is not needed during retirement, then simply withdraw the money and pay tax on the distribution like a traditional 401(k) distribution. Since the only money allocated to the HSA was money that initially was allocated to the Traditional 401(k), there is no taxation difference if the funds are not needed for medical expenses. One caveat — always make certain that you fund your 401(k) enough to capture the full employer match. Proper funding of a Health Savings Account can be a good way to maximize your retirement dollars. Tax laws are complicated, and penalties for mistakes can be costly. Make sure you seek out the guidance of a tax professional before making important financial decisions.
Examples are hypothetical and for illustrative purposes only. The rates of return do not represent any actual investment and cannot be guaranteed. Any investment involves potential loss of principal.
Clark D. Randall, CFP, is a financial planner, Registered Representative and owner of Financial Enlightenment, a financial services firm. Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Advisory Services offered through Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Financial Enlightenment & Cambridge are not affiliated.