Whenever retirement saving comes to your mind, the first plan that might pop up is the 401(k) retirement account. But did you know that your employer can even offer you an HSA (health saving account) to save while also spending less in your retirement? This article discusses everything you need to know about 401(k) and HSA in detail.
How a 401(k) Works
The 401(k) plan is a common employer-sponsored retirement plan. In this plan, the employees contribute money to their investment account through deductions in their payroll, and the employer can choose to match all or some of this contribution. You can choose from different types of investment accounts, mainly mutual funds, for your 401(k) plan.
There are two types of 401(k) retirement plans – Traditional and Roth. In the traditional 401(k) retirement account, your contributions will reduce the total taxable income for the year; however, you will have to pay income tax once you withdraw the funds from the account after retiring. The Roth 401(k) plan works the opposite. You have to pay taxes when you are making contributions to the account. But after retirement, your withdrawals are tax-free.
Rolling your existing 401(k) retirement account into a new 401(k) or IRA retirement account is possible, but only if your plan allows it. Moreover, some retirement plans even grant rollovers if you have changed your organization.
How an HSA Works
HSA, Health Savings Account, is designed to help individuals cover their medical expenses. But some people even use them as a retirement savings account for their future. To contribute to this account, you must first have a high-deductible health plan (HDHP). You cannot possess any health coverage plan or even enroll for Medicare. Moreover, no one else can add you as a dependent on their tax returns.
Once you have an HSA, the funds collected can only be used to cover expenses like co-insurance, deductibles, and co-payments. You cannot use the contributions made in an HSA to pay premiums. The funds in your HSA account accumulate and grow tax-free. You even enjoy tax-free withdrawals made for medical expenses. In case you don’t use the entire balance available in your HSA account for the entire year, the money will roll over in the next year.
What are the Contribution Limits?
Every year, the IRS (Internal Revenue Service) decides on a contribution limit for every retirement account. The 401(k) contribution limit (both traditional and safe harbor) was $20,500 in 2022. For the calendar year 2023, it has been increased to $22,500. This does not include the catch-up contribution limit. You can start adding catch-up contributions to your retirement account once you reach the age of 50 or above at the end of the calendar year. For catch-up contributions in the 401(k) plan, you can make $7,500 in 2023. This was $6,500 from 2020 to 2022 and $6,000 from 2019 to 2015.
For HSA’s retirement plan, if you have self-only HDHP coverage, you can contribute up to $3,850; if you have a family HDHP coverage, the contribution limit is $7,750. In 2022, the contribution limits were $3,650 for a self-only plan and $7,300 for family coverage. The catch-up contribution limit for 55 and older people is $1,000. The HDHP maximum out-of-pocket amount you can contribute in this plan, which includes co-payments and other amounts (excluding premiums), is $7,500 for self-only and $15,000 for family.
What are the Tax Benefits and Considerations?
The main benefit of opening a 401(k) retirement account is that they are tax-deferral. This means that the money you contribute is pre-tax, and your taxable income for the contribution year is less. In simpler words, you are not paying any taxes on the money you contribute until you reach retirement age when you start making withdrawals. This happens in the traditional 401(k), while in the Roth 401(k), money is contributed after income taxes, meaning you contribute tax-deducted money, so you don’t have to pay taxes while withdrawing after retirement.
One thing to consider before contributing to a 401(k) plan is that if you withdraw funds before you reach the retirement age (50 ½), you will have to pay a 10% penalty, unless you qualify for the hardship withdrawal, in which you can avoid the penalty but not other taxes. A hardship withdrawal is when you need to withdraw from your retirement account but cannot repay it.
Similarly, the HSA is a tax-advantaged account where you can save on pre-tax, but the withdrawals are made tax-free when you use those funds for carrying your medical expenses. The expenses included in the qualified list are curated by the IRS Publication 502, and it mainly includes hearing aids, dental treatments, and eye tests. And if you withdraw from this account to pay for anything that is not health-related, you incur a 20% penalty along with income tax on the distribution. There’s an exception for non-medical related withdrawal for people with disabilities or above the age of 65.
Which One to Choose?
Why choose when you can contribute to a 401(k) plan and HSA in the same year? If your goal is to save for medical expenses primarily, make HSA a priority. Although the 401(k) plan does allow you to make hardship withdrawals, the rules are stricter, and even income tax is applied. But investing in both accounts makes more sense if you are at a stage where you can max out your retirement contributions.
Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning firm based in Goodyear, AZ. He has over three decades of experience working with investments and retirement planning. Over the last 10 years, he has turned his focus to self-directed accounts and alternative investments.