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Health savings accounts: A second retirement plan

Ask around for retirement advice and you are likely to hear a familiar refrain: Start saving early, and put enough into your 401(k) plan to capture the maximum matching contribution from your employer.

But some experts argue that many investors are passing up (or underutilizing) a powerful savings tool — the triple tax-advantaged health savings account — in their pursuit of a secure retirement. Greg Geisler, an associate professor of accounting at the University of Missouri–St. Louis, is one such expert.

In an article published earlier this year in the "Journal of Financial Planning," Geisler argues that, in many cases, workers with both employer-matched 401(k) plans and HSAs are better off from a wealth-building standpoint prioritizing contributions to HSAs.

A patient is monitored in an examination room inside the Clinical Decision Unit at Kaiser Permanente's Capitol Hill Medical Center in Washington, D.C.
Brooks Kraft LLC | Corbis | Getty Images
A patient is monitored in an examination room inside the Clinical Decision Unit at Kaiser Permanente's Capitol Hill Medical Center in Washington, D.C.

"HSAs," wrote Geisler, "need to be incorporated into financial planners' recommendations to individuals."

"The proper advice to some individual clients," he added, "may be to maximize contributions to their HSA first and then contribute enough to their 401(k) to get the maximum employer contribution second — instead of the traditional advice to get the maximum employer 401(k) match first."

Health savings accounts — authorized by the Medicare Modernization Act of 2003 — are available only to people enrolled in high-deductible health insurance plans meeting strict criteria, including certain minimum deductibles and out-of-pocket maximums. As with 401(k) plans, HSAs typically offer a menu of investment options.

The estimated number of Americans covered by HSA-eligible health plans stands at 22 million and is growing at a fast clip of about 25 percent a year, according to the Health Savings Account Council at the American Bankers Association. Most HSA-eligible health plans are employer-sponsored, but the plans are also sold through the exchanges created under the Affordable Care Act.

In theory, HSAs encourage consumers to save for future medical expenses and spend more prudently on health care since they are using their own money. According to some advisors, HSAs are also the Holy Grail of savings vehicles because of their rare triple-tax benefit. Contributions to HSAs are made with pretax dollars (in most states), assets grow tax-free, and distributions are tax-free if used to pay for qualified medical expenses or as reimbursement for such expenses.

"With an HSA, money goes in tax-free, builds up tax-free and, as long as it is pulled out for a qualified medical expense, comes out tax-free." -Paul Fronstin, director of health research at the Employee Benefit Research Institute

Unlike workplace flexible-spending accounts, HSAs don't have a "use-it-or-lose-it" rule and are "portable," meaning workers who are no longer covered by HSA-eligible health plans because of job changes can continue to tap existing HSAs to pay for qualified medical expenses.

What's particularly enticing to some savers is the fact that withdrawals for qualified medical expenses can be taken at any time. For instance, retirees with balances that have been building over time can take tax-free withdrawals for qualified medical expenses incurred years earlier.

There is no need to provide proof of having incurred qualified medical expenses to take withdrawals, but it's wise to keep records in case of an Internal Revenue Service audit of your HSA distributions, experts say.

"With an HSA, money goes in tax-free, builds up tax-free and, as long as it is pulled out for a qualified medical expense, comes out tax-free," said Paul Fronstin, director of health research at the Employee Benefit Research Institute. "You get a better tax break [on withdrawals for qualified medical expenses] than you get with a 401(k) or an individual retirement account."

Amy Hubble, a certified financial planner, said HSAs can be a powerful retirement-savings vehicle for younger people and those without children, who typically don't have big medical expenses and are able to let their balances compound over long periods.

Hubble tries to convey this message to clients whose benefits at work include HSA-eligible health plans. But she has found that some clients are reluctant to choose high-deductible coverage and forgo the traditional co-pay for doctors' visits.

"For people who don't visit the doctor very often and can stomach paying the rare visit out of pocket, the ability to compound investment growth over a long working lifetime can be incredibly powerful," said Hubble, founding principal of Radix Financial.

Hubble points out that one of the primary reasons to save for retirement is to put aside money for medical expenses, which can be daunting for older Americans. Fidelity Investments estimates that a couple, both age 65 and retiring in 2015 with Medicare as their primary insurance, will need $245,000 in today's dollars for health-care costs during retirement.

According to Geisler at the University of Missouri-St. Louis, for many employees the tax savings on contributions to HSAs increases wealth by more than an employer match on 401(k) contributions.

"The fact is that if your employer 401(k) match is low enough and your combined tax savings on HSA contributions is high enough, you'd amass more wealth by making HSA contributions first." -Greg Geisler, associate professor of accounting at the University of Missouri-St. Louis

"The fact is that if your employer 401(k) match is low enough and your combined tax savings on HSA contributions is high enough, you'd amass more wealth by making HSA contributions first," he said. "I'm not saying don't contribute to both; I'm saying the math recommends maxing out what you can put into your HSA each year."

Like other savings vehicles, HSAs have both advantages and limitations. There are, for instance, relatively low caps (indexed for inflation) on yearly contributions. For 2016, the maximum contribution is $3,350 for an individual and $6,750 for a family. Those age 55 or older can make an additional $1,000 yearly "catch-up" contribution.

"If you are using an HSA purely as a retirement savings vehicle and not taking advantage of your 401(k), your contributions will not amount to a lot of money and are probably not going to cover health-care expenses in retirement," said Fronstin of the Employee Benefits Research Institute.

What's more, withdrawals from HSAs for anything other than qualified medical expenses are subject to income tax, plus a hefty 20 percent penalty tax. For those 65 and older, non-qualified distributions are subject to income tax, but not the penalty tax.

In addition, some health-care experts argue that HSA-eligible health plans may actually discourage lower-income consumers from getting needed care because of the out-of-pocket costs. In a 2015 survey by the nonprofit Commonwealth Fund, two out of five adults with deductibles representing 5 percent or more of their incomes reported that they avoided getting care, including preventative tests, because of their deductibles.

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High-deductible health plans have lower premiums than traditional HMO- or PPO-type plans and have caught on with employers seeking to reduce their premium costs. Many companies contribute premium savings to employees' HSAs.

"What we have found is that low- or moderate-income people with high-deductible plans tend to avoid getting needed care because of the cost," said Sara Collins, vice president for the Health Care Coverage and Access program at The Commonwealth Fund.

As it turns out, people with higher income levels are more likely than those of modest means to opt for HSA-qualified health plans, because they are less concerned by the potential out-of-pocket medical costs and more interested in the tax savings, according to Fronstin at EBRI.

Despite the growing popularity of HSA-qualified plans, it may be just a matter of time before they are no longer offered through insurance exchanges. According to the American Bankers Association, the U.S. Department of Health and Human Services recently issued a regulation that would effectively eliminate the plans from exchanges beginning next year, causing an estimated 2.8 million Americans to lose their coverage.

The regulation "revives the whole 'if-you-like-your-health-plan-you-can-keep-it' problem," said Kevin McKechnie, executive director of the ABA's Health Savings Account Council. The ABA is calling on the Department of Health and Human Services to reconsider the regulation.

— By Anna Robaton, special to CNBC.com