Beware, 401(k)s: HSAs Are The New Retirement Sheriff In Town | Smart Change: Personal Finance

Saving some of your paycheck into a 401(k) is one of the best ways to prepare yourself for a happy retirement. But 401(k)s aren’t the only game in town when it comes to retirement planning. And one account in particular offers a slew of benefits over a 401(k) for those who qualify.

A health savings account (HSA) is designed to provide tax savings on medical expenses. But you can take advantage of all those tax savings and turn it into an incredible retirement account.

What is an HSA?

An HSA is a special account available to members of certain health insurance plans with a high deductible. The idea is that since you have a high deductible, the government wants to make it easier for you to pay for your medical care, thereby providing tax benefits on eligible expenses. You can contribute money to your HSA and you don’t have to pay taxes on qualified medical expenses when they arise.

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Unlike a flexible spending account, HSA funds never expire. Once they are in the account, you can always use them. Whether that’s next month or next decade, it doesn’t matter.

If you are offered an HSA through your employer, you can choose to defer pay and your employer may contribute to your HSA as well. These premiums are exempt from payroll taxes and income tax. You can also contribute directly to an HSA, but with funds on which you have paid payroll taxes.

Unlike a 401(k), you have immediate access to HSA funds. If you use the money for qualified medical expenses, you don’t pay tax on the withdrawal. Otherwise you pay income tax. If you are under 65, you will also owe a 20% penalty for an unqualified withdrawal.

How to make the most of it

You can get the most out of an HSA by using it as an investment account. With various providers you can invest in a wide range of funds and other securities.

Unlike a 401(k), you are not limited to the provider supported by your employer. If your employer creates an account with a more restricted provider, you have the right to move your money wherever and whenever you want.

If you can afford to pay for your medical expenses with money outside of your HSA, do so and keep the receipts. Archive them somewhere you will have access to in many years to come. When you are ready to withdraw money from your HSA to fund your retirement, you can submit your receipts and make a withdrawal.

Ultimately, this strategy offers superior tax benefits to a 401(k). Firstly, contributions paid through payroll taxes are exempt from payroll taxes. They are also exempt from income tax. The growth of your investments is also tax protected, so you pay no capital gains tax. And if you only have qualified distributions (because you kept your receipts), you don’t pay income tax on the withdrawals, either. A 401(k) can usually get you just two out of four of those tax breaks.

If you are over age 65, you can start taking benefits for unqualified expenses and pay income tax only. In that case, the HSA essentially functions like a traditional IRA. That is not recommended, however, as you will likely have a lot of medical expenses that you can use your HSA for later in life. Tap your other retirement savings first before going down this path.

The downside of the HSA is that its contribution limits are much lower than a 401(k). For 2022, the limits are $3,650 per year for an individual and $7,300 for a family. This includes any employer contributions. In comparison, employees can contribute up to $20,500 to a 401(k), and that’s in addition to employer contributions.

But if you qualify for an HSA and are in a strong financial situation, it probably makes sense that you maximize your contribution, invest it and use it as a retirement account.

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