How to Fund Your HSA and 401(k)

Bigger tax benefits for HSAs means more workers are funneling funds there. Is that smart?
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Many employees can now contribute to both an employer-sponsored health savings account and a 401(k) plan.

And they are. But an interesting trend is developing. Workers are reducing how much they contribute to their 401(k) in order to contribute to their HSA, according to new research published by the Employee Benefit Research Institute (EBRI).

“Not only does the amount of 401(k) contributions decrease as HSA contribution levels increase, the higher the 401(k) contribution, the greater the reduction in 401(k) contribution among those who contributed to their HSA for the first time,” Paul Fronstin, a director at EBRI and co-author of the report, Two’s a Crowd: Do HSA Contributions Crowd out 401(k) Contributions?, said in a news release.

“The EBRI research results tell me people are understanding that HSAs double as retirement savings vehicles,” said Kelley Long, who refers to herself as a financial bliss coach. “So, it makes sense to prioritize fully funding your HSA before overfunding your 401(k) beyond an employer match.”

And it makes sense, especially given the triple-tax benefits of HSAs compared with 401(k) plans.

As with a 401(k), contributions to an HSA are tax-deductible and any growth is tax-free. But unlike a traditional 401(k) where distributions are taxed as ordinary income, distributions from an HSA, when used on qualified healthcare expenses, are tax-free.

What’s more, employers are more likely to both contribute to a worker’s HSA as well as match employee contribution. By contrast, it’s not as common for employers to contribute to an employee 401(k) beyond matching contributions.

So, if you have both an HSA and a 401(k), what’s the best way to fund those accounts?

According to Steve Feinschreiber, senior vice president and head of methodology at Fidelity Investments, the general rule is that you should start by at least contributing as much to your HSA as you plan to take out.

By doing this you convert what would have been an after-tax expense (your out of pocket expenses) into a pre-tax expense since withdrawals from HSA are tax-free for medical purposes, said Feinschreiber. “The tax savings can even be used to increase your 401(k) savings,” he said.

The next money you have should go to contributing to the 401(k) up to the match, said Feinschreiber. “Money you have after that should go to maxing out the HSA and then maxing out the 401(k). Of course, you would figure it out all at once and make elections for the whole year depending on how much money you have available for savings, not literally take steps throughout the year,” he said. 

For her part, Long recommends the following:

  1. For new HSA participants, you want to put at least $1 in your HSA when it’s first opened to officially establish it;
  2. Then save in your 401(k) to any employer match;
  3. Then save in your HSA up to the maximum allowable amount for the year;
  4. Once your HSA is fully funded, then go back and either increase 401(k) contributions or fund a Roth IRA if applicable.

Another adviser agrees with that strategy. “There definitely are measurable benefits to contributing in a jump pattern -- i.e., go after the employer matches for both first and then continue funding up to the caps as best you can,” said Steve Devaney, president of Aisling Advisors.

There’s another good reason to fund your HSA and not just your 401(k). It might help you avoid raiding your 401(k).

According to Long, the biggest reason workers raid their 401(k) accounts before retirement is to cover unexpected medical bills, whether that’s taking out a 401(k) loan, which incurs interest and reduces their paycheck, or worse, they take a hardship withdrawal, which can incur penalties and taxes.

“Having those funds instead available in an HSA, where the withdrawal is tax-free, is a huge alleviated burden,” she said.

It’s important to note that this strategy works best when you’re able to let your HSA money accumulate and you invest it for that tax-free growth, said Long. “However, if the alternative is accumulating credit card debt, then funding HSA in order to receive the tax deduction on qualified expenses you’re incurring anyway makes sense,” she said.

Funding an HSA also provides financial opportunities not necessarily available with a 401(k). For instance, you can use the HSA to pay for Medicare Part B premiums, home healthcare expenses, or expenses in an assisted living facility. What’s more, some experts say you can use the funds in the HSA to pay for previously incurred medical expenses. Read Planning for Long-Term Care (LTC) Expenses? Consider an HSA Strategy.

For some, one way to fund your HSA quickly is to roll money into it from your IRA. Read Ask Bob: Rollover from IRA or 401(k) to an HSA.

Another Point of View

Another expert, Marcia Mantell, president of Mantell Retirement Consulting, offers this take on the funding question.

For the highest income wage earners, they, she said, can usually afford to fully fund both 401(k) and HSA -- and maximize contributions. This year’s limits: $19,500 to 401(k) plan; $6,500 catch up; plus, $7,200 HSA and a $1,000 catch up. This strategy pulls $34,200 out of taxable income. “Very few workers could afford to defer this much income,” she said.

For those with more “regular” incomes, Mantell said they face a few challenges, particularly how to balance their savings versus paying the bills.

“When these employees participate in their 401(k), the goal is to get them contributing to get the full match,” she said. “If the match is 50% on the first 8% of contributions, this worker has to defer 8% of his paycheck to get the 4% match. How much more can s/he reasonably defer?”

For many households, a good guideline, she said, is 60/30/10: 60% of take-home pay is for essentials (mortgage/rent/food/insurance, etc.); 30% for consumer debt management and wants; and 10% for emergencies.

So, Mantell said, the question becomes: Can a person reduce their spending in the wants category and redirect that cash to an HSA to improve their current tax situation?

She gave this example: $100,000 gross income delivers a net income of about $71,000 after saving 8% in the 401(k) to get the 4% match. That’s roughly $6,000 per month. And the 60/30/10 formula equals $3,600/$1,800/$600.

“This person could likely redirect some of the $1,800 to an HSA,” she said. “But how much?”

The next level of decision making is how they will use the HSA – for current medical expenses or for the future?

If it’s for current expenses, Mantell recommends estimating annual out-of-pocket expenses and directing that amount to the HSA. “They’re going to spend it anyway, so they may as well get the tax benefits,” she said.

Her advice: Aim to save at least the out-of-pocket deductibles that their plan requires.

Long recommends that you avoid using your HSA for current expenses you can pay with savings on hand. “You can always go back and reimburse yourself in the future,” she said. “Let your HSA build up so that it’s there if you have a large expense that may otherwise cause you to take on debt. And if you don’t, then in retirement you can use it to pay your Medicare premiums, long-term care insurance premiums and once you’re 65, you can withdraw funds penalty-free for any purpose, although you will incur taxation if used for nonqualified expenses.”

Read Your HSA: Is It a Health Savings or Spending Account?

If you’re contributing to your HSA for future health expenses, Mantell said they might consider saving the same amount as the Part B premium each year. It’s an easy number to find and it gets one familiar with upcoming Medicare: $148.50 per month this year. Multiply it by two if you’re saving with a spouse, $297 per month.

Now, an individual with family coverage under a qualifying high-deductible health plan (deductible not less than $2,800) can contribute up to $7,200 for the year. That works out to $600 per month in 2021, which Mantell said is one-third of their “‘wants’” bucket and probably much too high.”

If an employee expects to receive an employer contribution, Mantell said it would be good to meet that first and get the “free money” into the HSA.

“Keep in mind that the worker is already paying a hefty amount in premiums to get health insurance,” she said. “Routing even more dollars to healthcare can be a daunting prospect. But the tax benefits are real, and the fact is that healthcare in America is very expensive.”

Mantell’s perspective is that we need to create and address more “rooms in the financial house.”

So, instead of 60/30/10, maybe it’s:

  • 10% retirement (your contribution; employer match and Social Security additional)
  • 60% needs/essentials
  • 10% healthcare in an HSA, which does not include premium paid to be in the plan
  • 15% debt and fun
  • 5% emergencies

“It’s not pretty, but the reality is healthcare costs are eating up the American worker’s budgets,” said Mantell. “We need to take it from a hidden expense out into the open so they can deal with it in a meaningful way. Ten percent might not even be enough. But something in a specific healthcare bucket is always better than nothing in the bucket.”

It also puts, she said, equal weight on retirement savings and healthcare. “So long as a worker is getting the full match, it’s a good idea to redirect money into health savings. Contribution limits are much lower, but tax benefits are significant.”