HSA or 401(k)?

I recently had a conversation with someone regarding the benefits of Health Savings Accounts (HSAs) and 401(k)s. For the most part, I would say that people better understand the savings and tax advantages associated with 401(k)s than they do with HSAs. Although HSAs have been around for over a decade and more employers are providing access to them as part of their health-plan offerings, there are many individuals that still don't quite understand their savings and tax advantages, let alone any complementary benefits with 401(k)s.

First, it is important to know that HSAs are triple-tax advantaged, which means contributions allocated to such accounts are tax-free, any investment earnings grow tax-free, and any distributions for qualified health expenses are tax-free. A lot of individuals don't think about how to save for health-care in retirement, yet it's one of the major expenses people will have. Many people overlook HSAs as a retirement-savings vehicle, but these accounts offer even more tax advantages than 401(k)s and individual retirement accounts (IRA)s when used to cover medical costs, which are a major expense in retirement.

Using an HSA to save for retirement medical expenses can, often, be a better strategy than using retirement accounts to cover those out-of-pocket qualified expenses. Not only would using one's retirement savings be a potential drain on one's income, with a traditional 401(k) or IRA, you pay income tax on your withdrawals, whereas, as I mentioned above, you don't with HSAs.

So, HSA or 401(k)? Well, maximize both if you can! According to a Wall Street Journal article, many financial experts recommend that those who can afford to contribute to both an HSA and a 401(k) contribute the maximum to both. However, for many folks that is often not doable, so the recommendation is the following. Some experts say if there is no 401(k) match, fund the HSA first. Most agree that, if there is an employer matching contribution, take advantage of that and then direct the next dollars of savings to the HSA. To figure out if a retirement contribution would grow to a larger sum in a 401(k) or health savings account, look to your combined federal & state tax rate and any 401(k) match to make your decision.

It is, also, important to remember that you can also use your HSA for nonmedical expenses post age-65, without incurring a penalty tax (although you will pay ordinary income tax on your distributions). If your goal is to use an HSA to save for medical expenses in retirement, be sure to invest the account in a diversified portfolio. Often times, participants don't realize that they may have an option to invest all or a portion of their HSA savings in stocks and bonds and other investment vehicles.

The costs of health-care in retirement is expected to be astronomical for many individuals, especially as life expectancy increases. With the disappearance of employment-based retiree medical plans, individuals will need to save much more to fund their premiums and out-of-pocket health-care expenses in retirement. A build-up of savings in health savings accounts can certainly help to offset these expenses, but, often, medical emergencies can neither be avoided nor budgeted, nor is the savings enough. Even with the best efforts, individuals may not be able to save and have enough for their out-of-pocket medical expenses, either now or during their retirement.

However, at the very minimum, both employers and employees should be well-educated in the advantages of health savings accounts, 401(k)s, and other retirement savings vehicles in order to make sound decisions impacting one's future financial success.