More often than not, when people think of retirement savings, the thought of their company health insurance plan doesn’t cross their mind. It’s about time that it does.
In fact, for some people (though certainly not all) money placed in a health savings account (HSA) will be more beneficial at retirement than money in an IRA or a 401(k) plan. This can be true even when considering an employer match. Please keep in mind that it is not my intent to explore whether an employee should choose a high deductible health plan (HDHP) or a traditional health plan.
Each has its merits, and this is a decision that should be made based on an individual’s ability to pay higher deductibles and their overall level of health. Rather, the goal is to bring to light the exceptional planning strategies afforded when one contributes to an HSA. Bear in mind that an HSA can be paired only with a HDHP. An HSA does not have a “use it or lose it” rule, and it is portable.
HSA Basics and Requirements
If an individual is enrolled in a HDHP and wants to contribute to an HSA they cannot also be covered by a traditional health plan. For 2023, the maximum total contribution allowed from the employer and employee combined to an HSA is $3,850 for an employee with self-only health insurance coverage, and $7,750 for an employee with family coverage. These amounts are indexed for inflation and will rise to $4,150 for an individual and $8,300 for a family in 2024. For an individual age 55 or over, an additional $1,000 contribution is allowed. Any employer contributions are tax free to the employee.
For a plan to be an HDHP, two requirements must be met. First, the annual deductible for 2023 can be no less than $1,500 for an individual employee’s self-only coverage and no less than $3,000 for family coverage. In 2024, the annual deductibles will be $1,600 for an individual and $3,200 for a family. Second, the maximum annual deductible and other out-of-pocket expenses for 2023 can be no more than $7,500 for self-only coverage and no more than $15,000 for family coverage. These amounts are indexed for inflation, with max out of pocket limits reaching $8,050 for an individual and $16,100 for families in 2024.
HSA as a Retirement Vehicle
The retirement planning strategies arise from the second-to-none tax treatment given to HSAs. Money isn’t taxed on the way in or the way out, as long as it’s used for medical purposes. An individual’s contributions to an HSA are not subject to federal income tax, state income tax or FICA taxes if made through an employer’s HSA plan.
It should be noted that California and New Jersey tax both HSA contributions and earnings. New Hampshire and Tennessee both tax earnings on annual amounts depending on all combined dividends and interest earnings. In states without state income tax, like Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming, the state income tax benefit isn’t applicable.
A contribution to a 401(k), on the other hand, skips only income taxation. Inside the HSA, the employee’s contributions are invested, and future earnings on such investments are also tax free aside from the exceptions already listed.
Distributions from an HSA are tax free as long as they are used for qualified medical expenses (QMEs). For the sake of brevity, QMEs are generally defined as out-of-pocket health care expenditures allowed as itemized deductions on an individual’s tax return. However, to be tax free, the distribution cannot be for QMEs that were taken as itemized deductions in any year, because “double-dipping” of tax benefits is not allowed.
Withdrawals at Retirement
Here’s where an HSA gets really interesting. Should an individual decide to use their HSA for retirement expenses rather than living expenses, they are able to withdraw from the HSA (at age 65 or later) and pay income taxes on the distribution. Distributions prior to 65 are taxed and subject to a 20% penalty. Distributions from IRAs and qualified plans are taxed in a similar fashion, with the penalty being 10% for distributions prior to age 59 ½.
401(k) or HSA?
We’ve determined that an HSA can be a great retirement strategy, but is contributing to a 401(k) or HSA first more beneficial for you? According to the Journal of Financial Planning, here’s the math:
- If an individual’s combined tax rate is greater than 20 percent and his or her employer’s match is 25 percent or less, contribute to the HSA before contributing anything to the 401(k).
- If an employee’s combined tax rate is greater than 33 1/3 percent, and his or her employer’s match is 50 percent or less, contribute to the HSA before contributing anything to the 401(k).
- If an employee’s combined tax rate is greater than 42.86 percent and his or her employer’s match is 75 percent or less, contribute to the HSA before contributing anything to the 401(k).
- If all three of the previous statements are false, then the wealth-maximizing order for the employee is to contribute enough to his or her 401(k) to get the maximum employer match before contributing to his or her HSA.
This assumes that the money stayed in the HSA until retirement instead of being spent on health costs. There is one other assumption made in the above calculations that is very important to remember: that the quality of investments (and the fees for said investments) in the 401(k) and the HSA are equal. In practice this is rarely the case. A quality advisor will be able to help evaluate which option is best for you. Contact Claris with any questions on your particular situation.