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Why You Should Max Out Your HSA Before Your 401(k)

Considering that most employers are offering a high-deductible HSA-eligible health insurance plan, chances are that you’ve at least heard of health saving accounts (“HSAs”) even if you’re not already enrolled in one. People who are used to more robust coverage under HMO or PPO plans may be hesitant to sign up for insurance that puts the first couple thousand dollars or more of health care expenses on them, but as the plans gain in popularity in the benefits world, more and more people are realizing the benefit of selecting an HSA plan over a PPO or other higher premium, lower deductible options. For people with very low health costs, HSAs are almost a no-brainer, especially in situations where their employer contributes to their account to help offset the deductible. If you don’t spend that money, it’s yours to keep and rolls over year after year for when you do eventually need it, perhaps in retirement to help pay Medicare Part B premiums.

But HSAs can still be a great deal even if you have higher health costs. Higher income participants looking for any way to reduce taxable income appreciate the ability to exclude up to $6,750 per year from taxes for family coverage (plus another $1,000 if turning age 55 or older), even if they end up spending the entire amount each year. It beats the much lower FSA (flexible spending account) limit of $2,550 even if out-of-pocket costs may be higher.

Because HSA rules allow funds to carryover indefinitely with the triple tax-free benefit of funds going in tax-free, growing tax-free and coming out tax-free for qualified medical expenses, I have yet to find a reason that someone wouldn’t choose to max out their HSA before funding their 401(k) or other retirement account beyond their employer’s match. Health care costs are one of the biggest uncertainties both while working and when it comes to retirement planning. A large medical expense for people without adequate emergency savings often leads to 401(k) loans or even worse, early withdrawals, incurring additional tax and early withdrawal penalties to add to the financial woes. Directing that savings instead to an HSA helps ensure that not only are funds available when such expenses come up, but participants actually save on taxes rather than cause additional tax burdens.

The same consideration goes for healthcare costs in retirement. Having tax-free funds available to pay those costs rather than requiring a taxable 401(k) or IRA distribution can make a huge difference to retirees with limited funds. Should you find yourself robustly healthy in your later years with little need for healthcare-specific savings, HSA funds are also accessible for distribution for any purpose without penalty once the owner reaches age 65. Non-qualified withdrawals are taxable, but so are withdrawals from pre-tax retirement accounts, making the HSA a fantastic alternative to saving for retirement.

To summarize, when prioritizing long-term savings while enrolled in HSA-eligible healthcare plans, the order of dollars should go as follows:

Contribute enough to any workplace retirement plan to earn your maximum match.
Then max out your HSA. (For 2017, the maximum annual contribution, including employer contributions, is $3,400 for single coverage and $6,750 for family coverage, plus a $1,000 catch-up contribution for HSA holders age 55 and older.)
Finally, go back and fund other retirement savings like a Roth IRA if you’re eligible or your workplace plan.

Contributing via payroll versus lump sum deposits

Remember that HSA contributions can be made via payroll deduction if your plan is through your employer, and contributions can be changed at any time. You can also make contributions via lump sum through your HSA provider, although funds deposited that way do not save you the 7.65% FICA tax as they would when depositing via payroll. For people who still want to max out for 2016 but can’t get there via payroll, you can make lump sum deposits for 2016 up until the April 17, 2017 tax filing deadline, as long as you were enrolled in the plan in 2016.

The bottom line is that when deciding between HSA healthcare plans and other plans, there’s more to consider than just current healthcare costs. An HSA can be an important part of your long-term retirement savings and have a big impact on your lifetime income tax bill. Ignore it at your peril.

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