Retirement savings are on everyone’s mind these days, regardless of age or number of years in the workforce. Millennials are concerned they’ll never be able to retire, while baby boomers are choosing to delay retirement — in part because of employer demand for their expertise in the face of a low unemployment rate, but also because many of them haven’t sufficiently saved for retirement. In fact, according to Time’s Money division, 28 percent of boomers and seniors aged 55 and older don’t have any retirement savings whatsoever and just over half have less than $50,000 saved.
Even more surprising, the median amount Americans have saved for retirement is just $5,000, which means we have a long way to go in helping people prepare for their golden years. This number may seem staggeringly low — and it is. The average retirement savings among Americans age 32 to 61 is just under $96,000. However, averages are pulled up by super-savers, so this number seems artificially high.
With the prevalence of high deductible health plans (HDHPs), a lot of people are now enrolled in health savings accounts (HSAs). While people are mostly familiar with the short-term savings opportunities these accounts provide for healthcare expense reimbursement, many are also realizing that HSAs are a viable retirement savings option as well.
This begs the question — if people had to choose between investing in their 401(k) or maxing out their HSA for the year, which one is a better retirement savings option?
Retirement Savings Options: Using an HSA as a Retirement Savings Vehicle
As an employee, if you have access to an HSA, you should try your best to make contributions which at least offset the out-of-pocket qualified medical expenses you’re incurring. (Note that this particular contribution strategy matches how you’d typically approach a “use-it-or-lose-it” FSA.)
This is possible since HSA contributions are adjustable throughout the year, provided you don’t exceed the annual contribution caps, which are $3,600 for self-only coverage and $7,200 for family coverage in 2021. (If you’re over the age of 55, you can kick in an extra $1,000 in “catch up contributions.”)
These contributions are critical to taking advantage of the tax benefit of an HSA, which allows you to pay for eligible expenses with pre-tax dollars. Here’s an example of how of this saves you money:
If you have a prescription that costs you $50 per month and you paid for it as you normally pay for anything else, you’d have to earn about 25 to 30 percent more than that at your job to ensure your take home pay was at least $50. But when you pay for this prescription with pre-tax dollars from your HSA, you don’t have to worry about that. And these savings can really add up — a 30 percent tax savings on the $7,200 family contribution cap would yield over $2,100 in extra purchasing power.
Where retirement saving strategies come into play is when an account holder contributes more than they’re spending annually, thus yielding unspent HSA funds. Although an HSA’s primary role is to serve as a savings account to offset the cost of high-deductible health plans, they eventually become a viable retirement savings option if and when unspent balances remain in the account.
Here are five important things to remember about HSAs:
- HSA funds never “expire,” which means pre-tax contributions continue to add up over the years.
- HSA funds can be invested (depending on the plan administrator) into mutual funds and other investment vehicles, adding tax-free compounding growth to these accounts.
- Participants over the age of 65 can withdraw money to pay for non-medical expenses, although the funds will be taxed as income. (Prior to age 65, participants get hit with a 20 percent penalty on withdrawals for non-medical expenses, in addition to being taxed as regular income.)
- Participants who only use these funds for qualifying medical expenses, even into retirement, get a triple tax break: They get the pretax benefits of an IRA, the tax-free withdrawal benefits of a Roth IRA, and the tax-free growth benefits of both.
- Upon a participant’s death, their spouse becomes the owner of the account and can use it as if it were his or her own HSA. If the participant is not married, the account will no longer be treated as an HSA upon their death. The account will pass to their beneficiary or become part of their estate (and be subject to any applicable taxes).
How HSAs Stack Up Against 401(k)s
401(k)s are the most commonly offered retirement savings option offered by for-profit employers (403(b)s are the most common among not-for-profits). These accounts allow both the company and the employee to make contributions in a variety of ways, including matching programs and profit-sharing.
Many financial experts agree it’s probably best to max out your 401(k) before treating your HSA as a retirement vehicle, meaning that it only makes sense to overfund your HSA (beyond anticipated qualified medical expenses) if you’ve reached your maximum contribution limit in your 401(k), which is $19,500 in 2021 (and if you’re over 50, you can contribute an additional $6,500 in “catch-up savings”).
Note that this does not mean you shouldn’t participate in your HSA. It simply means that if you have extra savings to put toward retirement, you should put it first towards your 401(k) (and you should never pass-up a company match on any retirement investment).
The main reason being that, while it’s true that HSAs offer tax advantages and an opportunity to build up savings to spend in retirement, HSAs don’t operate the way traditional retirement plans do. HSAs also aren’t under the same level of scrutiny and oversight as more traditional retirement savings vehicles. For example:
- Costs could be higher. 401(k) plans are required to be more transparent about various account and investing fees than HSAs. Depending on the provider, participants might include a monthly account fee, check-writing fee, or other transaction fees.
- Investment options are limited. Most HSA administrators require a minimum balance before participants can invest (typically a few thousand dollars). HSA investments are typically limited to mutual funds and other FDIC-insured savings accounts, while 401(k)s offer much broader investment opportunities.
- Participants incur withdrawal penalties. HSA withdrawals for non-medical expenses, before age 65, will incur a 20 percent penalty and participants will also owe tax on those withdrawals. 401(k) participants can typically take a loan from their plan. Though there are drawbacks to doing so, there aren’t IRS penalties (in fact, you can pay yourself back with interest).
Making the Choice
According to industry estimates, the cost of healthcare in retirement could be $200,000 or more, and using an HSA as a tax-advantaged account strictly for medical bills is smart. But with HSAs, the fees can be costly, the investment and withdrawal options limited, and the triple tax benefit is only realized if you spend the money on medical expenses.
All that being said, if you’re in a fortunate enough position to max out your other retirement plans, you may then want to max out your HSA as well. It does, after all, raise the cap on tax-deferred savings.
From the Employer Side of Things
While this post has been primarily focused on which savings account functioned better as a retirement savings option, employers also should take into account which one works to further their benefits strategies. Of course, the answer depends on your unique situation.
If your objective is employee retention, some argue that a 401(k) with matching contributions works better than an HSA, especially if the employee matching vests over a certain time period.
On the other hand, if your objective is cost savings, offering an HSA company match (or other incentive) for employees who enroll in an HDHP will probably save you more money than a 401(k) match. Even accounting for an HSA matching contribution, you’re still likely to have lower expenses than you would with more traditional health plans.
The good news is that, just like your employees, you don’t really have to choose between these two retirement savings options. You can offer and contribute to both — and you can do so, with thoughtful plan design, in such a way that you still save money.
What questions do you have about retirement savings options? Leave us a comment below or contact us. We’re happy to provide answers!
Editor's Note: This blog post was originally published on May 24, 2018 but updated to reflect 2021 IRS contribution limits.