When an HSA-First Strategy Makes Sense

Why the standard advice about the sequence of contributions to a 401(k) plan and health savings account is flawed--and must-know advantages of HSAs.

W. Scott Simon


Many–perhaps most–articles about health savings accounts suggest that employees with an HSA who participate in a 401(k) plan should first contribute to the 401(k) plan the percentage of their compensation that enables them to obtain the maximum plan sponsor match, such as 3% on the employee’s first 6% of compensation. Employees should then max out their HSA account contributions through payroll deductions. Once that’s done, they should go back to contributing any additional dollars to their 401(k) plans.

While this strategy is indeed attractive, an even better one would be to change the sequence of the contributions. That is, employees should first max out contributions to their HSAs no matter their tax bracket, and once that’s done, contribute to their 401(k) plans.

Break out that trusty old HP 12C and calculate any contribution, time horizon, and interest-rate combination. Then reduce that number by, say, 25% for tax to come up with the 401(k) balance. (An HSA demonstrates even greater superiority over an employer match in a 401(k) plan when withdrawals are made at a tax bracket higher than 28%, thereby illustrating the power of tax-free withdrawals in retirement. That is, the higher an employee’s tax bracket, the larger the employer’s 401(k) match must be to in order beat contributing to an HSA first.)

A 401(k) plan will beat an HSA if left to retirement. However, reality intrudes when withdrawals are made from the 401(k) to pay for things like medical expenses and a participant in a 401(k) is slammed with taxes and penalties. This is why it makes the most sense to first max out HSA contributions and thereafter get the maximum company match from the 401(k).

Do the same for an HSA but then factor in a 7.65% (FICA) discount up-front and no tax deduction at the back end. In most calculations, the HSA-first strategy is ahead by one third. Then, add in a typical employer match of 3% on the first 6% in employee compensation and take the balance out at a 35% tax bracket. The result: HSA tax savings even beat the employer’s match. And don’t forget, 80% of employers that offer an HSA contribute $500-1,500 to an employee’s HSA.

Once these two no-brainers are accomplished–max out HSA contributions first and then obtain a full company match for the 401(k) plan–only at that point should employees begin their retirement needs planning for the year and so on into the future.

For those who are uncomfortable with this strategy for whatever reason, perhaps they would prefer contributing simultaneously to both the HSA and the 401(k) account on a regular periodic basis throughout the year.

Apart from the issue of the sequence of contributions to an HSA and a 401(k) plan is the issue of the difference in the amount of contributions. For example, Employee A saves and invests $5,000 (a nice round number used even though it slightly exceeds what an individual 55 or older can currently contribute annually to an HSA) annually for 30 years in an HSA. Employee B also saves and invests $5,000 annually for 30 years in a 401(k) account. Employee A in the HSA will amass $611,729 while Employee B in the 401(k) plan will amass $423,699.

The differential in favor of the HSA of nearly $200,000 is due to avoiding payment of the (up-front) 7.65% FICA tax (or more in certain other states and localities) for 30 years of contributions. (Assumptions for the foregoing terminal amounts include a 25% income tax bracket, an 8% return, an HSA that’s in the payroll deduction scenario to avoid paying 7.65% in FICA taxes and HSA assets are used for qualified medical expenses. Also, a 25% income tax bracket was applied for withdrawal of 401(k) money.)

Tax-Deferred Accumulation of Earnings and Interest on Contributions

Any earnings and interest generated on contributions to an HSA accumulate tax-deferred over time. When these accumulations are used to pay for qualified medical expenses or to reimburse an HSA holder for previous qualified medical expenses, they become tax-free distributions.

Tax-Free Distributions to Pay for Qualified Medical Expenses

In essence, HSA assets can be used to pay for anything tax-free. Suppose that HSA holders are able to max out contributions to their HSAs and pay for qualified medical expenses out-of-pocket through some or all of their careers. If the holders have kept their medical expense receipts over time, they can get reimbursed later for those expenses from their HSAs.

There’s not even a need to have a current qualified medical expense; the HSA holder merely needs to have a receipt from any time in the past to get reimbursed. Qualified medical expenses, then, can arise from any year–not just the current one. This proactive strategy allows an HSA holder to augment retirement income tax-free rather than first pulling money from, say, its taxable 401(k) plan account. This could be helpful in cases where withdrawals from a 401(k) account could bump the holder into a higher tax bracket which could also result in higher Medicare premiums

Other instances of the versatility and flexibility of the HSA abound. For example, the fact that an HSA holder can contribute to an HSA until April 15 for the previous tax year (like an IRA) allows for a post- calendar year tax avoidance strategy. Suppose that a 56-year old self-employed worker had $4,000 in medical expenses and paid for them with (after-tax) out-of-pocket money because the worker didn’t know that he or she was eligible for an HSA. A savvy investment advisor informed the worker about eligibility.

So before tax-time in April, the worker establishes an HSA and contributes $4,000, thereby avoiding payment of federal and state income taxes. (But not FICA taxes because the self-employed cannot establish an IRS section 125 cafeteria plan. However, LLC or LLP members might be able to establish a 125 plan if they have elected to be taxed as a Subchapter C Corporation; competent professional counsel should be consulted in such cases.) The worker then took out $4,000 from his or her HSA to reimburse himself/herself.

The result: a wash that saves a lot in taxes. This post-calendar year tax avoidance strategy demonstrates again that having a receipt for qualified medical expenses that were paid even far in the past allows an HSA holder to get reimbursed–assuming, of course, that the holder has been able to pay for its medical expenses out-of-pocket along the way.

Additional Advantages of HSAs

The Tax Cuts and Jobs Act passed by Congress last year failed to further expand the advantages of HSAs. However, it’s thought that there will be a Medicaid/Medicare HSA provision as well as one to increase HSA contribution limits included in the 2018 Budget Reconciliation Act. In the meantime, here are some additional advantages of an HSA.

Full Vesting. Any contributions made to an employee’s HSA by either the employee or its employer are immediately vested in the employee.

Portability. An HSA can be opened by a worker anywhere. For example, if employees don’t like their employer-sponsored HSAs, say, because it’s pricey and/or the investments are suboptimal (which is often the case), they can pull the assets from it and invest them elsewhere in an optimal HSA (within 60 days but without the rigmarole of a rollover). The downside to this non-payroll deduction scenario, of course, is that employees cannot take the 7.65% (or more) deduction for FICA taxes. Even if employees are currently ineligible to make contributions to their HSAs, the HSA always stays with them not their employers.

Flexibility. HSA holders can withdraw HSA assets or change them at any time while letting the HSA accounts accumulate, regardless of their current employer or current eligibility. In addition, there are no required minimum distribution rules or requirements to begin taking withdrawals at a certain age.

Sources of Contributions. Those other than HSA holders can contribute to a holder’s HSA including a family member and, as noted, their employers.

Coverage for Family. HSA holders can use assets from their own HSAs to pay for qualified medical expenses incurred by spouses and their tax dependents even if they aren’t eligible to establish their own HSAs or even if they have health insurance different than the holder.

At Death. At an employee’s death, the HSA can be rolled over to a spouse tax-free, plus that spouse can continue to save and invest in the HSA. But if the HSA is rolled over to a nonspouse, the HSA balance is fully taxable like the balance in a 401(k) plan.

Medicare/Retirement. The Medicare Part B monthly premium (for visits to the doctor) is deducted from a recipient’s monthly Social Security check. In such cases, however, an HSA holder can get reimbursed from HSA assets for these premiums as well as Part D monthly premiums (for drug prescriptions).

Next month’s column will answer the question raised in a previous column: how advisors can charge into the HSA marketplace to gather assets, and invest and manage them.

W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.

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