SHOULD YOU CONTRIBUTE TO AN HSA VERSUS AN IRA OR 401K?

SUMMARY: A HEALTH SAVINGS ACCOUNT CAN NOT ONLY HELP YOU WITH CURRENT MEDICAL EXPENSES BUT CAN ALSO BE USEFUL AS A RETIREMENT FUNDING VEHICLE. AND IT HAS TAX ADVANTAGES THAT ARE GENERALLY GREATER THAN THOSE APPLICABLE TO IRAs AND 401Ks.

Most people who save for retirement consider doing so on a tax qualified basis, such as through a 401k plan offered by their employer or through an IRA. This allows them to reduce their taxable income by the amount contributed and allows the funds to accumulate tax free until withdrawn. While withdrawals are subject to taxation at ordinary income tax rates (and, if withdrawn prior to age 59 1/2, to a 10% penalty tax), the advantages of immediate deduction and tax-free accumulation make this a very attractive retirement funding vehicle. But most people - and even some advisors - do not realize the value of an alternative way to fund for post-retirement needs: Health Savings Accounts or HSAs. 

An HSA is a tax advantaged medical savings account that is available to taxpayers who are enrolled in a High Deductible Health Plan - i.e., a health plan with higher deductibles and lower premiums than a traditional health plan.  Enrollees in a High Deductible Health Plan may establish and contribute to an HSA and use funds in the HSA to pay for medical expenses that are not paid by the High Deductible Health Plan, generally because of the high deductible. As in the case of an IRA or 401k, contributions that you make to the HSA are tax deductible up to certain annual limits ($3,350 for Singles and $6,750 for Families in 2016). Investment earnings on these amounts accumulate tax free, just as in the case of an IRA or 401k. But unlike an IRA or 401k, you may withdraw amounts from an HSA tax free and penalty free at any time - even before age 59 1/2 - as long as you use those amounts to pay for "qualified medical expenses" that are not paid for by your medical insurance. Any amounts left over in the HSA at the end of the year roll over into the following year and are available in that year - along with any contributions made in that following year - to pay for your "qualified medical expenses" in that year. This rollover process continues indefinitely and allows your HSA to grow with further deductible contributions and tax-free investment earnings even into your retirement years. And this is where the HSA really shines compared to an IRA or 401k.

Once you retire and become covered by Medicare, you will no longer be in a High Deductible Health Plan and, therefore, you will not be eligible to make further contributions to your HSA. However, you will be able at any time to withdraw the funds in your HSA to pay for any "qualified medical expenses" without any income tax liability on the amount withdrawn. And withdrawals after age 65 may also be used to pay for Medicare Part B premiums, Medicare Supplement premiums and even Long Term Care Insurance Premiums - all without incurring any income taxes on the withdrawals. That is a tremendous advantage over taking withdrawals from an IRA or 401k to pay medical expenses or premiums since those withdrawals are fully taxed at ordinary income tax rates. 

You should therefore include HSAs in your thinking as you consider your retirement funding options. You should think about retirement funding as not just providing a source of income - you should also think of it as providing a source of covering expenses that are certain to arise after retirement, such as medical expenses and health care premiums. Having a means of funding those expenses on a tax preferred basis such as through an IRA or 401k makes sense; having the ability to withdraw the funds when needed on a tax-free basis makes contributing to an HSA even more attractive.

There are, of course, certain HSA requirements that need to be adhered to. For example, "qualified medical expenses" include things like deductibles, copays, doctor visits, prescription drugs, etc. but do not include over-the-counter medications. And you should check with your insurer to make sure they are in a valid High Deductible Health Plan. Many employers offer High Deductible Health Plans to their employees and may even contribute to an HSA for them. And High Deductible Health Plans are available under the Affordable Care Act both on and outside state insurance exchanges. 

Finally, you should always take into account matching contributions by your employer to your 401k, if available, as you consider making contributions to an HSA. Generally, you should contribute to your 401k at least the maximum amount that your employer matches in whole or in part. This assures you of getting the most funds possible into a tax qualified retirement funding vehicle. But once that maximum match is achieved, you should consider contributing any additional funds you can afford to your HSA, up to the prescribed limits.