HSAs and 401ks—Better Together (Part One)

A supermajority of employers has denied their workers access to America’s most valuable benefits tax preference—the Health Savings Account (HSA). Only 17% of surveyed employers who offer health coverage offer an HSA-capable option.[i] Few use automatic features.[ii] Even fewer structure their employer HSA contributions as a match to encourage worker contributions.[iii]

For plan sponsors pursuing a “health and wealth” strategy, failure to offer a 401k and an HSA is a mistake. These two, better together, create a unique engagement lever.

Over-insurance impedes retirement savings

Consistent with Liberty Mutual’s tagline, workers should select health coverage so they “only pay for what you need.” [iv] Average spend on medical services for more than 50% of Americans is less than $400 a year.[v] Excluding Medicare-eligible Americans (age 65+ and disabled), health expenditure data suggest that four out of five Americans spend less than $1,000 a year on medical services.

“Plan sponsors can remove any barriers that would impede workers from maximizing the value from both the HSA and 401k.”

Unfortunately, many let biases control benefits decision-making. Many Americans are risk averse. Many are financially fragile. Biased decision-making leads many to purchase more medical coverage than needed.

Generally, HSA-capable coverage comes as a choice, often with a lower employee contribution coupled with higher point-of-purchase cost-sharing (deductibles, etc.) What biases prompt individuals to over-insure and reject HSA-capable coverage?

Recency and availability, where recent adverse events (satisfy a deductible) are prominent,
Possibility, when negative outcomes are possible but not probable (satisfy expense maximum),
Attentional, clue-seeking, focusing on point-of-purchase cost-sharing (deductibles, copays, coinsurance, out-of-pocket expense maximums) instead of total costs (e.g., Health Reform’s mandated disclosure – the Summary of Benefits and Coverage),
Uncertainty, just-in-case thinking,
Loss aversion, losses are perceived to be more impactful than an equal dollar gain, and
Commitment, confirmation, status quo, confidence in prior decision-making.

Further, many employers “nudge” workers to over-insure by limiting the coverage choices:

Framing, or naming coverage options based on the size of the deductible, excluding all other considerations,
Commitment, confirmation, status quo, retaining the existing options, and defaulting individuals to their current coverage election even when introducing HSA-capable coverage as a new choice.

Researchers found that workers who over-insure are more likely to forego employer-matching contributions for retirement saving. In one study, one-third of employees overpaid $1,700/year for health coverage and simultaneously made no voluntary retirement contributions. The losses were highest for employees with lower salaries, lower educational attainment and for women. Simply, consumers could redirect money away from health coverage to retirement savings without sacrificing consumption.[vi] However, a more accurate description is that by redirecting the savings from lower employee contributions, workers could invest those monies in their Health Savings Account—offering maximum utility along the way to and throughout retirement:[vii]

HSAs have become an integral component of a “health and wealth” strategy.
HSA assets can fund current or future medical, dental, vision, hearing and, long-term care (LTC) costs, Medicare and LTC premiums, in addition to providing an income in retirement or survivor benefits.
HSA assets offer more value than 401(k)s when using the accounts to pay for retiree medical expenses.
Even if all HSA assets are expended on pre-retirement qualifying medical expenses, they will help in retirement preparation by leveraging tax preferences.

The most tax-efficient way to reallocate funds currently spent as employee contributions for medical coverage would be to enroll in HSA-capable coverage and use cafeteria plan automatic enrollment defaults to redirect monies to the HSA. Other studies show consumers who are enrolled in HSA-capable coverage options are the most engaged of all health plan consumer categories.[viii]

Prioritizing savings—Which comes first, the “HSA chicken” or the “401k nest egg”?

Long ago, W. Scott Simon, then at Morningstar, argued in favor of prioritizing saving in the HSA before the 401k, asserting that: “… 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. HSA tax savings even beat the employer’s match.” [ix]

While I have been a champion of HSAs since 2004, I respectfully disagree with his prioritization. My decades of practical experience suggests a more nuanced approach based on each worker’s financial situation.

Best: For those who can afford it, max out both HSA and 401k contributions and do so as early in the year as possible. For an age 55+ single worker, that is almost $35,000 pre-tax in 2023.[x] Those who can afford such funding levels might also consider Roth. Why max out, and max out early? The future is guaranteed to no one.

Next best: Most workers can’t afford to save the max. Most retirement experts suggest savings of at least 15% of pay per year. So, workers should prioritize contributions so that:

The Health Savings Account is opened on the first day of HSA-capable coverage (to start the “claims clock” for tax-favored reimbursement of eligible expenses),
Workers contribute as necessary to obtain the maximum employer contribution to both the HSA and 401k as soon as possible, and then
Workers prioritize Health Savings Account contributions first – to leverage the HSA’s superior tax preference and to prepare for any unexpected medical expenses.

Note that many structure employer contributions to Health Savings Accounts so that they comply with the comparability requirements—allowing for considerable discretion on the timing of employer contributions. For example, some “front load” a portion or all of the employer contribution. For comparison, only 1 in 20 HSAs use a match similar to that used by many, perhaps most 401k plans.

For the rest—including the financially fragile: Many workers are financially unable or unwilling to contribute to both the HSA and the 401k at the same time. To ensure workers receive the full employer financial support, a plan sponsor will want to:

Update 401k plan liquidity provisions to allow for multiple loans, electronic banking, and to enable borrowing as soon as practical,[xi]
Immediately vest at least some of the employer financial support to the 401k plan (employer contributions to HSAs are always 100% immediately vested),[xii]
Change the employer match process (401k and HSA, as appropriate) to include a “true-up” each pay period[xiii],
Make a $1 employer contribution on the first day of HSA-capable coverage to start the HSA claims clock for eligible expenses[xiv], and
Auto enroll the worker in the 401k and HSA at contribution rates sufficient to qualify for the maximum employer financial support (match).

Much depends on your specific plan provisions, employer contributions, etc. Remember that HSA employee contributions, similar to 401k contributions in most plans, can be prospectively changed during the year—increased, reduced, stopped and (re)started. And, like 401k plans, plan sponsors can (re) enroll, or auto-escalate HSA contributions. Importantly, financially fragile workers may need to leverage the 401k’s tax-preferred liquidity to fund the HSA.

Plan sponsors can remove any barriers that would impede workers from maximizing the value from both the HSA and 401k by:

Using the above changes, coupled with some savvy default provisions, to accommodate the needs of the financially fragile, and
Adopt HSA-capable coverage starting December 1, 2022 (not January 1, 2023) to maximize tax-preferred retirement savings.

I am always interested in your comments, corrections, and suggestions. Happy to guide you in introducing the HSA alongside your 401k. Feel free to e-mail me at jacktowarnicky@gmail.com

Author’s note: Part 2 of this three-part series will compare HSAs and 401ks, confirm where they are complementary, when one is superior, and why they work best as teammates. Part 3 will highlight the top 10 risks in offering Health Savings Accounts.

Disclaimer No. 1: My comments are my own based on my past experiences in plan sponsor and consulting roles and do not necessarily reflect those of any employer or association I have been employed by or affiliated with, past, present, or future.

Disclaimer No. 2: Information was provided by individuals with knowledge and experience in the industry and not as legal or tax advice. The issues presented here may have legal implications, and you should discuss this matter with legal counsel prior to choosing a course of action. This article is intended to be informational only. It is not (and you/others should not use it as a substitute for legal, accounting, actuarial, or other professional advice. Any advice contained in this article was not intended or written to be used and cannot be used by anyone for the purpose of avoiding any Internal Revenue Code penalties that may be imposed on such person [or to promote, market or recommend any transaction or subject addressed herein]. You (others) should seek advice based on your (their) particular circumstances from an independent tax advisor.

[i] Kaiser Family Foundation, 2021 Employer Health Benefits Survey, 11/10/21, Accessed 10/13/22 at: https://www.kff.org/health-costs/report/2021-employer-health-benefits-survey/

[ii] Plan Sponsor Council of America (PSCA), 2021 HSA Survey, Table 33. Only 8.4% of surveyed organizations use a default or otherwise suggest a savings amount during annual enrollment. Accessed 10/13/22 at: https://www.psca.org/research/HSA/2021report

[iii] PSCA, Note ii, Table 17, supra. Only 5.1% of surveyed organizations use a match in allocating employer financial support to the Health Savings Account.

[iv] Liberty Mutual, customize your coverage, only pay for what you need, Accessed 10/13/22 at: https://www.libertymutual.com/

[v] J. Ortaliza, M. McGough, E. W. Twitter, G. Claxton, K. A. Twitter, How do health expenditures vary across the population? Kaiser Family Foundation, 11/12/21. “… the 50% of the population with total health spending below or equal to the 50th percentile accounted for only 3% of all health spending; the average spending for this group was $374 in 2019. Roughly 14% of the population had $0 in health expenditures in 2019. Health spending is concentrated even within populations with relatively high average health costs. Among people reporting fair or poor health, the top 10% of people with the highest health spending accounted for 50% of total health spending. Considerable spending variation exists between those who are 65 and over and those under the age of 65, with younger persons experiencing more concentrated health spending. In 2019, just over half of all health expenditures among adults ages 18 through 64 was concentrated in people in the top 5% of total health spending while almost half of all health expenditures among adults 65 or older was concentrated in people in the top 10% of total health spending. Accessed 10/12/22 at: https://www.healthsystemtracker.org/chart-collection/health-expenditures-vary-across-population/

[vi] L. Friedberg, A. Leive, B. Davis, Overpaying and Undersaving: Correlated mistakes in retirement saving and health insurance choices, Wharton, 2022, Accessed 10/13/22 at: https://repository.upenn.edu/cgi/viewcontent.cgi?article=1725&context=prc_papers

[vii] J. Towarnicky, Maximum Utility: Your HSA Can Do Quadruple Duty, Benefits Quarterly, First Quarter 2021

[viii] HSA Bank, Health & Wealth Index, 2022, Accessed 10/13/22 at: https://www.hsabank.com/hsabank/learning-center/hsa-bank-health-and-wealth-index

[ix] W. Scott Simon, 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. Morningstar, 1/4/18, Accessed 10/13/22 at: https://www.morningstar.com/personal-finance/when-an-hsa-first-strategy-makes-sense

[x] 2023 HSA maximum contribution is $3,850 (single), $7,750 (non-single), plus $1,000 per individual age 55+. Based on September CPI data, 2023 401k maximum contributions are expected to be: $22,500, plus $7,500 catchup for those age 50+.

[xi] Internal Revenue Code §72 does not specify a minimum loan amount. Plan loans can be structured to allow for borrowing of the entire vested account up to the first $10,000 of assets. Note that borrowing is not permitted from the HSA, and a 20% penalty tax applies to pre-age 65 distributions of HSA assets that aren’t used for eligible medical expenses.

[xii] Internal Revenue Service, Retirement Topics: Vesting, Graded vesting of employer contributions can occur over a period lasting as long as six years. Accessed 10/13/22 at: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-vesting

[xiii] J. Towarnicky, True-Up, Catch-up, What’s Up, 10/09/18, Accessed 10/13/22 at: https://www.psca.org/news/blog/true-catch-whats

[xiv] Author’s Note: Like the ZEBRA of old (Zero Based Reimbursement Account, curtailed in 1984), contributions to the HSA need not precede the date eligible expenses are incurred. That is, regardless of when the contributions arrive in the Health Savings Account, all eligible expenses incurred on or after the date the HSA account was opened will qualify for tax favored reimbursement.