What Beats the Tax Savings of a 401(k) or an IRA?
It’s a health savings account, the best way to put money away for retirement medical expenses
Your healthcare expenses in retirement will likely eat up a chunk of your cash flow. Medicare covers plenty, but on average, retirees end up paying for about 30% of their healthcare expenses, be it the premiums for Medicare, supplemental coverage, or care that is entirely out of pocket.
And given modern life expectancies, it’s wise to devise a retirement income plan that will support you into your 90s.
While 401(k) or individual retirement accounts are the go-to retirement accounts, you should also consider a relatively new – and indirect – way to save for retirement that offers better tax breaks than even your 401(k) and IRA: a health savings account.
HSAs were first available 15 years ago; as of year-end 2017, there were an estimated 5.9 million accounts with assets of $13 billion.
An HSA is a special tax-advantaged account you can use to pay for your current out-of-pocket healthcare costs. Or, and here’s the really good part, you can treat it like a long-term retirement account and just leave your contributions in the account – you can keep it in savings or invest in mutual funds – to grow, and then use it to pay for healthcare costs next year or 40 years from now.
Every dollar in your HSA offers a triple tax break. That’s what makes an HSA an even better deal than a 401(k) or IRA:
Tax break #1: Money you contribute to your personal HSA will entitle you to a tax break. If your HSA is tied to a workplace health plan, your contributions will be made with pre-tax income, effectively reducing your taxable income for the year. (Added bonus: Some employers kick in a contribution to an HSA).
If you are self-employed and purchase your own health insurance, your contributions to an HSA can be claimed as a tax deduction.
Tax break #2: Money in your HSA that you don’t use grows tax free. This works just like a 401(k) or IRA: While the money is parked inside the HSA, there’s no tax bill.
Tax break #3: Withdrawals from your HSA to pay for a “qualified medical expense” will be 100% tax free. (Qualified expenses are the usual suspects: prescription medications, out-of-pocket costs for medical tests, exams, hospitalization, dental care, etc. It can even be used for nursing home care or home healthcare costs.)
This is where HSAs pull ahead of your 401(k) and IRA. With a 401(k) and IRA you end up paying tax at some point. If you save in a traditional 401(k) or IRA, you typically get an upfront tax break on your contributions, which are deducted from your income, but every penny of your withdrawals will be taxed as ordinary income. If you save in a Roth 401(k) or Roth IRA, you essentially pay tax upfront. Your contributions come from after-tax income, with the trade-off that withdrawals will be tax free.
There’s no trade-off with an HSA. The HSA delivers both the upfront and the withdrawal tax break.
The retirement payoff
One of the hardest retirement planning steps is to think through what your tax bill might be like once you are retired. Retirement taxable income can add up:
Depending on your overall income, a portion of your Social Security benefits may be taxable.
As noted earlier, every penny you withdraw from a traditional 401(k) and IRA will be taxed as ordinary income. And once you are 70.5, you must start taking required minimum distributions from traditional retirement accounts. Uncle Sam wants his tax revenue!
Lucky enough to have a pension? That’s taxable income too.
Add keep in mind that your taxable income determines your Medicare premium and how much of your Social Security retirement benefit may be taxable. The higher your taxable income, the more you’ll pay.
Having an HSA that you can tap tax-free will help you tamp down your taxable retirement income.
For example, let’s say you need $5,000 for a covered expense. If you pull that $5,000 out of a traditional 401(k) or IRA, the $5,000 will be counted as ordinary income on your federal tax return (and state, where applicable). Pull the $5,000 out of your HSA and it will not impact your taxable income. It’s 100% tax free.
HSAs: How to qualify
To save in an HSA you must be enrolled in a high deductible health plan (HDHP.) In 2019, any individual with a health plan deductible of at least $1,350 and family plans with a deductible of $2,700 is eligible for an HSA. Sadly, increasing numbers of Americans are stuck with high-deductible plans. (The max out-of-pocket is $6,750 for individuals in 2019 and $13,500 for family plans.)
Switching to from a lower-deductible plan to a higher-deductible one to qualify for an HSA requires careful consideration of the costs and risks. Can you handle the higher maximum-annual out-of-pocket costs that can be charged by an HDHP?
If you can cover those potential costs out of your regular cash flow, or your emergency savings fund, an HSA can make sense. (And always remember that you can use your HSA account to pay for current expenses at any time; there is no rule that it must be used only in retirement.)
There is no income limit to who is eligible. In 2019, individuals can contribute $3,500, family coverage allows a $7,000 annual contribution. Anyone over 50 can add another $1,000 to those annual limits. Those limits are increased periodically to keep pace with inflation.
Even if we just use the current caps, tucking away $3,500 a year in an HSA and earning a 6% annualized return for 25 years will grow to more than $200,000. That’s $200,000 of tax-free income when used for qualifying medical expenses. If you still have HSA assets when you die, your spouse becomes the beneficiary and can continue to use the money for qualified medical expenses. When someone other than a spouse inherits the account, it becomes taxable money that can then be used for anything.