Personal Finance

This triple tax-advantaged account might beat your 401(k) plan

Key Points
  • Health savings accounts allow you to put away pre-tax or tax-deductible dollars into an account and have them grow free of taxes. You may use the money tax-free if it’s for medical costs.
  • Here’s a quirk: While your 401(k) contributions are subject to Social Security and Medicare taxes, contributions to your HSA are not.
  • Social Security and Medicare taxes equal 15.3% and are divided between the employer and employee.
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There's a savings account with a potential advantage over your 401(k) plan — and it just might help you save on taxes.

It's your health savings account, and it's offered alongside your high-deductible health-care plan (if you have one).

HSAs come with three main tax benefits: You can contribute to them on a pretax or tax-deductible basis, and your savings grow free of taxes over time. You can also make tax-free withdrawals to cover qualified medical expenses.

There's a fourth less well-known tax advantage: Contributions you make to your HSA on a pre-tax basis avoid Social Security and Medicare taxes, often known as FICA taxes (Federal Insurance Contributions Act).

The same applies to contributions your employer makes to your HSA.

Health savings account: A great 401(k) alternative
Health savings account: A great 401(k) alternative

This FICA tax is 15.3% that you share with your employer.

The point is so compelling, it can spur companies to make even larger employer contributions to workers' HSA accounts, said Aaron Pottichen, senior vice president of Alliant Retirement Consulting in Austin, Texas.

Indeed, in 2018, workers in high-deductible plans with HSAs received an average annual employer contribution of $603 for single coverage and $1,073 for family coverage, according to the Kaiser Family Foundation.

In 2020, you'll be able to contribute up to $3,550 to your HSA if you have self-only insurance coverage. This amount goes up to $7,100 for family plans

"The communication that we have is that every dollar you spend on your employees goes further because Uncle Sam isn't digging his hand into it," Pottichen said.

Extra tax savings

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For example, take a married employee who is in the 24% federal income tax bracket is setting aside $7,000 annually on a pretax basis into his HSA.

This person would save more than $535 annually in Social Security and Medicare taxes alone each year, according to Pete Isberg, vice president of government relations at ADP, a payroll company.

Further, those contributions aren't subject to federal income taxes, resulting in another $1,680 in annual savings, according to Isberg's calculations.

This participant would save even more if he or she resides in a state that doesn't subject HSA contributions to income tax.

See below for Isberg's example.

Tax Savings of a Health Savings Account under a Cafeteria Plan
Contribution: $7,000
Federal Income tax (24% bracket): $1,680.00
Social Security (6.2%): $434.00
Medicare (1.45%) $101.50
State Income tax (assume 6%) $420.00
Total: $2,635.50 38% savings

If that same participant invested the money that would've otherwise gone to taxes, and it grew at a 3% interest rate, his family would save $30,200 over 10 years, Isberg said.

Remember, companies split the cost of the FICA tax with their workers, so employers' contributions to HSAs also avoid this levy.

"Employers like health savings accounts because they also save on Social Security and Medicare taxes," Isberg said.

"In this example, an employer with 100 employees all taking advantage of an HSA under a cafeteria plan may save over $53,500 annually, that would otherwise simply be a tax expense," he said.

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Optimize contributions

The contributions you make to a traditional 401(k) plan aren't subject to the same tax treatment as your HSA savings.

While 401(k) plan contributions avoid federal income taxes, they still face the FICA tax. When you withdraw money from this retirement account, the distribution is subject to income taxes, plus a 10% penalty if you're under 59½.

Meanwhile, distributions from an HSA are tax-free if they're for qualified medical expenses. But if you pull the money out for other reasons, you'll pay income taxes and a 20% penalty that's in effect until you're 65.

"If you know you're using the money for those medical expenses, the HSA is much more attractive than putting the money in the 401(k)," said Eric Bronnenkant, CPA and head of tax at Betterment.

That said, you don't have to choose one account over the other.

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Here's how you can fund both your 401(k) and HSA, according to Debbie Freeman, CPA and director of financial planning at Peak Financial Advisors in Denver.

Contribute at least enough to get the match on your 401(k). This is free money. The most common match formula employers use is 50 cents on each dollar on the first 6% of pay, according to Vanguard.

Save at least enough in your HSA to meet your annual deductible. Cash left unused in your HSA rolls over into the future. "In the years you have excess funds or you didn't have to touch the account, start investing the money," Freeman said.

Got extra dollars to save? Max out your HSA and invest it for the long term. Stash any remaining dollars into your retirement plan.

"You know your contributions are going in and being immediately invested," Freeman said.

Here's how to get the most tax benefits out of a health savings account
Here's how to get the most tax benefits out of a health savings account