Top HSA Story of 2018: HSA Contributions Should Come First

HSAs are triple tax-free

With healthcare open enrollment season approaching, individuals electing a high-deductible health plan will soon have an opportunity to decide how much to contribute to their health savings account for next year.

My advice?

Contribute as much as possible. And prioritize HSA contributions ahead of your 401k contributions. Employees eligible to contribute to an HSA should max out their HSA contributions each year. Here’s why.

HSA payroll contributions are made pre-tax. When balances are used to pay qualified health care expenses, the money comes out of HSA accounts tax-free. Earnings on HSA balances also accumulate tax-free. There are no other employee benefits that work this way.

HSA payroll contributions are truly tax-free

Unlike pre-tax 401k contributions, HSA contributions made from payroll deductions are truly pre-tax in that Medicare and Social Security taxes are not withheld. Both 401k pre-tax payroll contributions and HSA payroll contributions are made without deductions for state and federal taxes.

No use it or lose it

HSAs are often confused with flexible spending accounts, in which balances not used during a particular year are forfeited. With HSAs, unused balances carry over to the next year, and so on, forever (at least until the individual passes away). HSA balances are never forfeited due to lack of use.

Pay retiree health care expenses

Anyone fortunate enough to accumulate an HSA balance that is carried over into retirement may use it to pay for many routine and non-routine health care expenses.

HSA balances can be used to pay for Medicare premiums, long-term care insurance premiums, COBRA premiums, prescription drugs, dental expenses and, of course, any co-pays, deductibles or co-insurance amounts the individual or spouse.

HSA accounts are a tax-efficient way of paying for health care expenses in retirement, especially if the alternative is taking a taxable 401k or IRA distribution.

No age 70 1/2 minimum distribution requirements

There are no requirements to take minimum distributions at age 70 1/2 from HSA accounts. Any unused balance at death can be passed on to a spouse (with a completed beneficiary designation in order to avoid probate). After the individual’s death, their spouse can enjoy the same tax-free use of the account, but non-spouse beneficiaries lose all tax-free benefits of HSAs.

Contribution limits

Maximum annual HSA contribution limits (employer plus employee) for 2019 are modest—$3,500 per individual and $7,000 for a family. An additional $1,000 in catch-up contributions is permitted for those age 55 and older.

Legislation has been proposed to increase the amount of allowable contributions and make usage more flexible. Hopefully, it will pass.

HSAs and retirement planning

Most individuals will likely benefit from the following contribution strategy when combining HSA contributions and 401(k) accounts:

• Determine and make the maximum contributions to the HSA account via payroll deduction. The maximum annual contributions are outlined above.
• Calculate the percentage that allows the individual to receive the maximum company match in their 401k plan. Make sure they contribute at least that percentage each year. There is no better investment anyone can make than receiving free money. You may be surprised that I am prioritizing HSA contributions ahead of employee 401k contributions that generate a match. There are good reasons. Besides being triple tax-free and not being subject to age 70 1/2 required minimum distributions, these account balances will likely be used every year. The individual may die before using any of their retirement savings. However, someone in the family is likely to have health care expenses each year.
• If the ability to contribute still exists, then calculate what it would take to max out contributions to a 401k plan by making either the maximum percentage contribution or reaching the annual limit.
• Finally, if they are still able to contribute and are eligible, consider contributing to a Roth IRA. Roth IRAs have no age 70 1/2 minimum distribution requirements (unlike pre-tax IRAs and 401(k) accounts). In addition, account balances may be withdrawn tax-free if certain conditions are met.

The contributions outlined above do not have to be made sequentially. In fact, it would be easiest and best to make all contributions on a continual, simultaneous, regular basis throughout the year. Calculate each contribution percentage separately and then determine what they can commit to for the year.

As the use of HDHPs becomes more prevalent, HSAs will continue to be an important source of funds for retirees health care expenses. Make sure employees maximize they use of these accounts each year.

Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton is an award-winning 401k investment adviser with over 30 years of experience. He has consulted with many Fortune 500 companies, including: Aon Hewitt, Apple, AT&T, First Interstate Bank, Florida Power & Light, General Dynamics, Houghton Mifflin Harcourt, IBM, John Deere, Mazda Motor Corporation, Northwestern Mutual, Northern Trust Company, Trek Bikes, Tribune Company, Underwriters Labs, and many others. Mr. Lawton may be contacted at (414) 828-4015 or bob@lawtonrpc.com.