401(k)s Beware: HSAs Are the New Retirement Sheriff in Town | Smart Switch: Personal Finance

(Catherine Brock)

In 2021, the Employee Benefits Research Institute (EBRI) reported that 56% of 401(k) participants reduced their 401(k) contributions in the first year they contributed to their health savings account (HSA). ). Are these savers smart retirement planners or are they making a critical retirement mistake?

Either answer could be true depending on the situation. However, the HSA does have an attractive set of benefits. Here are four reasons maxing out your HSA might be your smartest retirement move, even if it means lowering your 401(k) contribution.

1. Get a triple tax benefit

The 401(k) has two main tax advantages. One, you fund accounts with pre-tax money, which lowers your taxable income. And two, your realized 401(k) earnings, interest, and dividends are tax-deferred. Instead of paying taxes each year on those earnings, you expect and pay taxes on qualified retirement distributions.

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The HSA has these two tax benefits, plus one more. With an HSA, all the withdrawals you use to cover qualified medical expenses are tax-free. No other account has that feature.

Even better, you can make tax-free medical withdrawals any time you have sufficient funds in the account. You don’t have to wait until you’re retired.

2. Reduce one of your biggest expenses

The HSA’s triple-tax benefit addresses what could be your biggest and scariest living expenses in retirement. In 2021, the financial company Fidelity estimated that the average couple retiring that year would need $300,000 to cover out-of-pocket medical expenses in retirement. Fidelity has also advised seniors to expect their medical expenses to consume 15% of their annual income.

Using tax-free money to cover your health care bills creates big savings over time. Let’s say you currently pay 22% of your taxable income to the feds. With an HSA, you can bypass that tax dilution of your money to the extent you have medical costs.

3. Take non-medical distributions after age 65

Once you turn 65, you can make penalty-free non-medical withdrawals from your HSA. These are taxable, just like a 401(k) distribution.

Because of this feature, it’s difficult to overload your HSA. If it turns out you don’t need the money for out-of-pocket medical expenses, your HSA can work as a backup to your 401(k). You would make taxable withdrawals and use the funds to cover your living expenses.

4. Earn money for contributing

Many employers provide matching contributions to the HSA. These are less generous than the 401(k), but it’s still free money. As with your 401(k), it’s smart to take as many contributions as your employer is willing to provide.

And if you’re wondering how to prioritize the 401(k) and HSA mix, here’s one school of thought: Contribute enough to your 401(k) to get the full mix. Then maximize your HSA contributions. If you still have room to contribute after that, increase your 401(k) contributions, up to the IRS annual limit, if you can.

Combine your 401(k) and HSA

Your HSA and your 401(k) have the same broader purpose: to help you prepare financially for retirement. However, it is a mistake to see them as competitive offers. Your HSA and 401(k) complement each other, like any great sheriff’s deputy team. Use them both side by side to create the retirement you want.

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