HSAs Help Owners Overcome the Disadvantages of 401(k)-only Savings
by William G. (Bill) Stuart | Originally posted on LinkedIn
A recent article identifies five disadvantages of using only a 401(k) (or similar workplace-based plan) to save for retirement. Adding a Health Savings Account to the mix may ease some of those shortcomings.
The Motley Fool published an article last week outlining five reasons not to save for retirement exclusively in a tax-deferred 401(k) plan. The logic is unassailable. Of course, saving for retirement is important. But the article stresses the importance of diversifying retirement savings to overcome some inherent limitations of 401(k) plans.
Let's look at three accounts that offer tax advantages to retirement savers and see how adding a Health Savings Account to the retirement-savings mix addresses the drawbacks of 401(k) plans that the article discusses.
Three Types of Retirement Plans
Tax-deferred 401(k) or IRA: Contributions aren't included in taxable income (though payroll taxes apply). Distributions are always included in taxable income and are subject to Required Minimum Distributions (RMDs) - a government formula mandating a certain withdrawal rate every year until death - beginning at age 72. These plans give savers the biggest "bang for their buck," since a reduction in current consumption is deposited directly into the account before income taxes are applied. But the spending power of balances is reduced by taxes on distributions.
Roth 401(k) or IRA: All contributions are after-tax (payroll and income). Distributions are always tax-free and not subject to RMDs. The same reduction of current consumption results in a smaller balance than with a tax-deferred 401(k) plan (because the after-tax contribution is less than a tax-deferred deposit), but the smaller balance isn't taxed upon distribution.
Health Savings Accounts: Contributions aren't included in federal or state (except California and New Jersey) taxable income, nor are payroll deductions subject to payroll taxes. Distributions for qualified expenses are always tax-free.
Here are the five shortcomings of 401(k) plans cited in the article:
Limited Investment Options
With any workplace-based qualified retirement account, your investment options are defined by your company and its partner. Often the menu is limited to several dozen mutual funds. The goal is typically to create a set of "best in class" funds that's large enough to diversity risk but small enough that a less sophisticated investor doesn't suffer from "paralysis by analysis" and end up keeping most of her balance in safer, low-yield investments.
Health Savings Accounts also often limit investment options to several dozen mutual funds. But here's the big difference: You're not limited by your company's account partner's menu. Yes, most companies send employer contributions and your pre-tax payroll deductions to its preferred partner only. You can, however, establish a second Health Savings Account with more investment options and regularly move funds from one account to the other, without restriction.
Most employees can't move funds from their employer's 401(k) plan to a rollover IRA until they reach age 59 1/2 (or they leave employment and execute a rollover). That inflexibility may cost them dearly. My 401(k) plan balance grew substantially when I left a prior job, rolled my balance into an IRA, and invested a portion of my balance in Apple, Amazon, Google, and WEX stock. I didn't have access to any stocks in my 401(k) plan.
Fees
Traditional retirement plans rely heavily on mutual funds, which have underlying management fees. Those charges, which you don't see but are deducted from the funds' annual return, may be 1% of the fund balance. Other fees may be assessed to you, the account owner, as a quarterly or annual deduction in our account value - a line item on the list of account activity. Over time, these fees can rob investors of tens of thousands of dollars or more. That's money that you won't have available in retirement, even though it was the result of your contributions or account growth.
Health Savings Accounts mutual-fund investments aren't immune from high fees. As noted above, however, you can open a second Health Savings Account. You can choose an account with invisible fees by choosing one that offers low-cost mutual fund and stock investments. In contrast, you're generally stuck with the investments that your employer's 401(k) plan offers, as noted above.
You Can't Always Withdraw Your Money When You Want
This is more a feature than a shortcoming of a tax-deferred or Roth 401(k) plan. The account is designed to save for retirement, not to serve as a rainy-day fund to meet immediate financial needs. For that reason, investors have only limited opportunities to withdraw funds without penalty before age 59 1/2.
In contrast, Health Savings Accounts are designed to reimburse qualified healthcare expenses, regardless of when you incur them. A Health Savings Account is a rainy-day fund and a long-term savings vehicle. You determine when to withdraw funds for a qualified (or non-qualified, subject to taxes and penalties) expense with no taxes or penalties applied. A Health Savings Account is no substitute for an emergency savings account to cover other sudden, unexpected expenses (replacing a water heater or a set of tires, or paying a high deductible on a homeowner's insurance claim). But it's prudent to make regular pre-tax payroll contributions knowing that at some point - next week, five years hence, or in retirement - you'll probably face a high healthcare-related expense that you can't absorb in your monthly budget.
You May Be Forced to Withdraw Your Money When You Don't Want
This is potentially a big problem for some tax-deferred 401(k) plan or IRA owners. At age 72, owners must begin to take RMDs (referenced above). The amount of these mandatory withdrawals is calculated using a government formula based on each owner's account balance and expected lifespan. Many Americans save too little for retirement and therefore withdraw more than the RMD annually to meet their annual expenses. But others may have to withdraw more than they need, particularly if they live modestly, can supplement a year's budget with the sale of an asset (like a primary residence), or want to preserve balances after a year of poor investment performance.
Technically, the owner of a tax-deferred account doesn't have to make the RMDs. The federal government gives a strong incentive to do so, however, as the penalty for not doing so is 50% of the RMD. In other words, if your RMD is $40,000, you can keep the $40,000 in your account, but you must pay a $20,000 penalty.
Health Savings Account balances are never subject to RMDs. Owners alone determine when and how much to withdraw from their account. Unlike tax-deferred account owners, they don't have a silent partner - the federal government - who wants to be paid his cut of the loot. This freedom is especially important when owners want to manage their annual tax burden in retirement . . .
Less Control over Your Taxes
RMDs affect taxes in several ways. First, of course, is the income tax levied on all withdrawals from tax-deferred accounts, since all distributions are included in taxable income. Second, taxable income determines how much of your Social Security check - 0%, 50%, or 85%) is included in taxable income. Third, though it's technically not a tax, your monthly Medicare Part B premium increases with higher levels of taxable income in retirement.
In contrast, Health Savings Account distribution for qualified expenses are never included in taxable income. They're defined as reimbursements, not income. Therefore, withdrawals for qualified expenses never place you in a higher marginal tax bracket. They never affect the portion of your Social Security check that's included in taxable income. And they never trigger a higher Medicare Part B premium.
The Bottom Line
Many Americans understand the importance of saving for retirement (even when awareness exceeds execution). The accumulation phase is important. So too is the distribution phase, which most people overlook (or don't know exists) until they're approaching or into retirement, when their options are limited. Health Savings Accounts are not the answer to retirement savings. But they are an important component to your having more control over your finances and taxes in retirement. They're an account worth funding for the long term.
William Stuart is director of strategy and compliance at Benefit Strategies, LLC, an administrator of Health Savings Accounts and reimbursement accounts. You can read and subscribe to his Health Savings Account GPS blog here and read his weekly HSA Monday Mythbuster and HSA Wednesday Wisdom columns and occasional Healthcare Update column published on LinkedIn.
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