Prioritizing HSA Contributions and 401(k) Contributions

An employed person able to realize similar rates of return may come out ahead by first maximizing contributions to their health savings account before funding the retirement plan account.

Under certain circumstances, it may make sense to prioritize contributions to a health savings account (HSA) over contributions to a workplace retirement plan such as a 401(k) plan or a 403(b) plan. An employed person able to realize similar rates of return may come out ahead by first maximizing contributions to the HSA account before funding the retirement plan account.

The rationale for the strategy is based on the tax rules. Contributions to HSAs not made by your employer are tax deductible. Withdrawals from HSAs are tax-free if they are used to pay for qualified medical expenses. Contributions to 401(k) plans are tax-free, but withdrawals are taxed at ordinary income rates.

In discussing the strategy, W. Scott Simon, a principal at Prudent Investor Advisors, treated the 7.65% FICA tax (which includes both Social Security and Medicare) as applying to 401(k) contributions, but not HSA contributions. He also assumed a worker would continue making annual contributions of $5,000 to each account for a period of 30 years. Future withdrawals from the retirement plan account were assumed to be taxed at a 25% rate. Given these conditions, the HSA was found to be worth $611,729 while the 401(k) was found to be worth $423,669 on an aftertax basis.

There are various caveats to consider. Depending on the investment options available, the expense-adjusted returns for an HSA may not be as high as they are for a 401(k) or 403(b) plan account. Simon’s analysis assumes no withdrawals will be made from the health savings account prior to retirement. Employer matches to either type of account were excluded. Simon discussed a 50% employer match on the first 6% of contributions made to the workplace retirement plan, but then suggested discounting them by a 35% tax rate. In reality, withdrawals of employer contributions will be taxed at the then-prevailing ordinary income tax rate.

Once in retirement, HSA withdrawals can be used to pay for qualified medical expenses. Because such withdrawals are tax-free, they can be used to reduce the amount that would otherwise be withdrawn from a workplace retirement account or a traditional IRA. This may help prevent a retiree from being bumped into a higher tax bracket.

Source: “When an HSA-First Strategy Makes Sense,” W. Scott Simon, Morningstar Advisor Insights, January 4, 2018.