While conventional strategies typically call for making employer-sponsored 401(k) funding a client’s top priority, many clients may wish to reconsider this strategy and consider the potentially significant benefits of moving health savings account (HSA) funding to the top of the list. 

For healthier clients with limited resources and health insurance deductibles that can exceed $7,000 annually, contributing to an HSA first is a no-brainer—those funds will continue to grow over time, and will also provide a safety net for future health expenses.  But the strategy can prove valuable as a savings plan even for clients who anticipate more significant health expenses in the short-term—and in either case, the tax math makes reevaluating traditional contribution ordering worthwhile.

HSA vs. 401(k)

Most traditional strategies dictate that a client should first contribute to an employer-sponsored 401(k) to the extent needed to gain the benefit of a full employer matching contribution.  Despite this, clients (especially those in higher tax brackets) should reconsider the savings potential of an HSA both currently and down the road.

Contributions to both HSAs and 401(k)s are made on a pre-tax basis.  However, HSAs provide the added benefit of also saving the client the 7.65% FICA tax if the client deposits the funds via payroll deduction related to the employer’s Section 125 cafeteria plan.  Further, employer contributions to the HSA are made on a post-FICA basis.

401(k) withdrawals are generally taxed at ordinary income tax rates, and HSA withdrawals are tax-free if used for medical expenses, but will be subject to income taxes and a 20% penalty if withdrawn for non-medical expenses (unless the client has reached 65, when the funds can be withdrawn for any purpose without the penalty).

With smart planning, a client who is able to cover the cost of out-of-pocket medical expenses pre-retirement can ensure that he or she will be able to withdraw the HSA funds tax-free during retirement (or at a future date) simply by saving his or her medical expense receipts.  As long as the client did not claim the medical expense as an itemized deduction on a prior tax return, the HSA funds can be withdrawn tax-free even years after the expense was actually incurred.

A client who incurs higher than anticipated medical expenses can access the HSA tax-free, but the 401(k) funds would be fully taxable (and, if the account is a 401(k) and the expense is the cost of health insurance while the client is unemployed, the 10% early withdrawal penalty will apply—if the client is receiving unemployment compensation, the HSA funds would be tax-free).

Clients also have until their tax filing deadline to contribute to an HSA for the prior year (so clients have until April 17, 2018, to make HSA contributions that can reduce their 2017 taxable income), giving the client additional time to contribute.

Post-Retirement Planning With HSAs

Upon reaching age 65, the client can withdraw HSA funds for any purpose without penalty. The income will be taxable as ordinary income, just as funds withdrawn from a traditional 401(k) are taxed.

Because unused funds in the HSA never expire, the client’s annual contributions can be left in the account to grow on a tax-deferred basis for years if the funds are not needed to cover medical expenses—creating an additional source of tax-free funds in retirement. As a result, many clients can accumulate substantial account balances that can serve to supplement traditional retirement savings vehicles.

Despite the fact that HSA funds can be used for any purpose after age 65, most clients are actually likely to incur medical expenses on the road to retirement that can make tax-free withdrawals from an HSA an attractive option. These clients can still take advantage of the tax-deferred growth on the account value, because, as discussed above, HSA funds do not have to be withdrawn in the year the expense was incurred in order to be withdrawn tax-free.

Further, while health insurance premiums are not treated as qualified medical expenses according to IRS rules, premiums for Medicare Parts A and B, as well as qualified long-term care insurance premiums, are expenses that can be withdrawn tax-free.

Conclusion

While it is important for clients to take advantage of an available employer match, for some clients the benefits of a fully-funded HSA can be just as important—and can provide significant future benefits as a tax-free source of income in retirement. 

For previous coverage of planning strategies involving see HSAs in Advisor’s Journal,  for and in-depth analysis of HSAs, see Advisor’s Main Library.

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