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This Retirement Account Can Be Better Than a 401(k) and an IRA

Rita Williams, The Motley Fool

If you're saving for retirement, you've surely heard of 401(k) plans and individual retirement accounts (IRAs). Both provide opportunities to invest long-term for retirement and offer tax benefits to help your investments to grow.

Contributions to 401(k)s and traditional IRAs are tax deductible, so you only pay taxes when you withdraw the funds. Contributions to Roth IRAs, by contrast, are initially taxed in the year you make them, and then enjoy no taxation upon withdrawal.

A stethoscope lies on top of fanned-out hundred-dollar bills.
A stethoscope lies on top of fanned-out hundred-dollar bills.


Sounds good, right? But there's a lesser-known retirement account that can be an even better option than 401(k) plans and IRAs: a Health Savings Account (HSA).

As the name implies, HSAs were developed to help folks pay for healthcare expenses. Specifically, these savings vehicles are meant for people whose health insurance policy qualifies as a high-deductible health plan (HDHP) by having a minimum yearly deductible of $1,350 for individuals and $2,700 for families. If you don't have an HDHP, you don't qualify for an HSA. (The minimum out-of-pocket expenses are $6,750 for an individual or $13,500 for a family.)

If you do qualify for an HSA, you can contribute a maximum of $3,500 each year for individuals and $7,000 each year for a family, if you're under 55. People who are 55 and older qualify for an extra $1,000 in catch-up contributions each year. This money is put aside and saved for when you need it to pay for a broad list of qualified healthcare expenses, including doctor visits, hospitalization, and prescription drugs, according to the Internal Revenue Service (IRS). You can read a complete list in IRS Publication 502, "Medical and Dental Expenses."

Saving and paying for healthcare spending is the chief benefit of HSAs, but let's examine how HSAs compete with 401(k)s and IRAs as more general retirement savings vehicles.

1. Contributions stay in your HSA indefinitely

Unlike the Flexible Spending Account (FSA) which has a use-it-or-lose-it rule, money you put in your HSA never has to be forfeited. Any funds you put aside and don't spend on healthcare expenses during one year rollover into the next year, forever and with no expiration date.

Let's say you start funding an HSA when you're 35 and have $500 left over after paying your healthcare expenses that year. With an FSA, that $500 would sprout wings and fly away, never to be seen again. But with an HSA, you keep the $500 until you're 65, or 85, or older. There's no limit, so you can use it when you need it. Plus, unlike a traditional IRA or a 401(k) there is no required minimum distribution (RMD) that kicks in at age 70 1/2 forcing you to withdraw money from the account.

And here's the kicker: Once you turn 65, HSA funds can be withdrawn and used for absolutely anything. You can still use them for healthcare costs, sure. But if you're hankering for a trip to Paris or Bermuda, that money you've saved can go toward travel as well.

2. HSAs give investors a triple tax advantage

HSAs provide investors with a rare combination of all three tax advantages -- it's the only retirement vehicle that sports all three.

First, the contributions you make to an HSA are tax-deductible, meaning you save on taxes in the year you contribute by reducing your taxable income by the amount of your contribution. This benefit is shared by 401(k)s and traditional IRAs. If you make $55,000 and contribute $3,000, for example, you'll pay taxes on only $52,000 that year. Your HSA contribution could even bump you into a lower tax bracket, so you pay a lower percentage of your income in taxes.

Second, money in your HSA grows tax-free, a quality shared by all three retirement savings vehicles. Interest, capital gainsand investment increases are all tax-free.

Third, when you withdraw money from your HSA, it is also tax-free. The only other account with tax-free withdrawals is the Roth IRA -- and its contributions are not totally tax-free because you pay tax on that money before contributing it. The sole exception to this triple-tax play is if you withdraw money from your HSA before you're 65 for non-medical expenses, because then the HSA withdrawals are taxed and the IRS levies a hefty 20% penalty.

3. HSA accounts can be invested in the stock market

Funds in your HSA account, like 401(k)s and IRAs, can be invested in the stock market for the long term, so the balance grows over time rather than languishing in a low-interest environment.

Many HSAs require participants to have a certain balance saved before the sum can be invested. But once you save that amount in your account, choosing to invest those savings can really help you fund your retirement. Why? Because over the long term, the U.S. stock market has returned an average of 7% to 8% yearly -- considerably higher than the return on fixed-income investments or letting your balance sit in an account and lose value as inflation outpaces its growth rate.

If you save $1,000 in your HSA when you're 35 and invest it until you're 65, that amount alone could rise to $7,612.26, assuming an annual 7% rate of return.

The overwhelming majority (96%) of HSA contributors don't invest the money, instead treating the account as a short-term vehicle for healthcare costs. It can also be a long-term one, for both healthcare and life in retirement more generally.

Some employers also contribute to HSAs by matching your savings or even funding your entire deductible. It's worth checking to see whether yours does. Free money to invest plus a triple tax play? It doesn't get much better than that.

4. HSAs help you pay for major healthcare costs in retirement

HSAs are especially beneficial for retirement purposes because older people incur a lot of medical expenses, which don't come cheap. In fact, the average cost of healthcare for retirees is growing higher each year.

A 65-year-old couple will need an estimated $399,000 in savings, according to the Employee Benefit Research Institute -- and that's assuming participation in Medicare and Medigap Plan F, a fairly comprehensive supplement. An HSA can help foot the medical bills that come due.

Healthcare is an expense that tends to climb steadily in retirement, as you age. That estimated $399,000 savings figure is nearly 8% higher than the estimate from the year before. The rise in healthcare costs has outpaced cost-of-living adjustments (COLAs) in Social Security benefits by a wide margin, according to The Senior Citizens League. From 2000 to 2018, Social Security COLAs rose 46% while premiums for Medicare Part B rose 195% and average annual out-of-pocket prescription drug costs increased 188%, which is more than four times as much as the COLA.

Older people are more likely to have chronic illnesses than younger people, and they will almost surely develop other medical conditions during retirement and into their older years. Long-term care doesn't come cheap, either. With illness comes increased healthcare needs, and the more healthcare you require, the higher those bills coming in will be and an HSA can be on your side.

Health Savings Accounts were initially designed for healthcare expenses, but they can also be used as a retirement savings vehicle. HSAs are even more advantageous than 401(k)s and IRAs and are worth considering, if you're eligible by having a high-deductible health plan.

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