Contribute to an HSA, Not a 401K

Why would I suggest contributing to a Health Savings Account (HSA) instead of a 401(k) retirement account? It is simple, HSAs provide “triple-tax-free” benefits on qualified medical expenses plus you can treat the account like a “sleeper retirement account” once you reach age 65. Hold on, don’t reach for the phone yet. Like any great tax “loop-hole” the IRS is going to make you jump through a few hoops to get the benefits.

Triple-tax-free benefits means you receive (1) a deduction for contributions, (2) the account can be invested and grow tax deferred, and (3) tax-free distributions can be made for qualified medical expenses. Now compare the HSA to a 401(k) which offers a deduction for contributions, but distributions will be taxable.      

How do HSAs work? Be sure to read Kim Richters’ article in the fall 2019 KT addition for the complete details. Now that you are refreshed on HSAs, let’s see the numbers!

As illustrated in exhibit A, Frank and Jill pay $2,000 per year for out of pocket medical expenses (which they can’t deduct due to Adjusted Gross Income limitations). They also contribute $3,500 into their 401(k)s over the employer matching limits ($2,730 out of pocket due to income tax deduction). Fast-forward 20 years, assuming a 7% rate of return, Frank and Jill’s 401(k)s would be worth $143,500. Assuming a top marginal tax rate of 22%, the after tax value of the 401(k) is $112,000. Now let’s look at Rich and Mary that use an HSA instead of a 401(k).

Rich and Mary contribute the same $4,730 after tax dollars as did Frank and Jill, resulting in an HSA contribution of $6,725. Rich and Mary withdraw $2,000 from the HSA per year to cover qualified medical expenses and the remaining $4,725 grows in the HSA account tax deferred. After 20 years Rich and Mary have $193,700 in the HSA, which is $50,200 more than Frank and Jill’s 401(k). Assuming Rich and Mary use the HSA to reimburse medical expenses and Medicare premiums, Rich and Mary will have $81,700 in after tax benefits over the 401(k) option Frank and Jill used while making the same contribution. How did the HSA provide the extra after tax benefits over the 401(k)?

Rich and Mary contributed to the HSA via their paychecks and effectively enjoyed a 29.65% deduction on $2,000 of annual medical expenses. This percentage is higher than their income tax rate of 22% as they saved 7.65% in payroll taxes.  Frank and Jill do not enjoy this payroll tax savings from the 401(k) contributions. In addition, Rich and Mary are not paying income taxes on HSA distributions for qualified medical expenses, and as such, are effectively deducting these medical costs.             

Employers can benefit from offering HSAs as well. HSA contributions made through payroll reduce payroll taxes for both the employer and employee. If an employee contributed $7,100 to an HSA, the contribution would result in $543 payroll tax savings for the employer. It does not take long for the savings to stack up.   

Many individuals are turned off by high deductible health insurance plans. However, I have found some great benefits. When I compared the low deductible plans to the high deductible plans, I found that if I paired the high deductible plans with an HSA and maxed out the annual contribution, the high deductible plan premium and the HSA contribution were about the same cost as the low deductible plan premium. Plus my HSA balance increases every year. Not all plans and tax situations are the same. Meet up with your favorite Ketel Thorstenson, LLP tax advisor and do the math. You might find a nice “loop-hole”.

HSA Fun Facts:

• There are absolutely no taxable income limitations.
• There is no requirement to reimburse medical expenses in the year paid. You can hold onto your receipts and take reimbursements later while the funds grow tax-deferred.   
• HSAs have no Required Minimum Distributions.
• You are allowed a once in a lifetime transfer from an IRA to an HSA, but this will reduce your annual contribution limitation.
• HSA’s can pay for or reimburse COBRA premiums.