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You're probably well-aware that you need to be saving for your future, and for your eventual retirement. But how exactly does one go about that? What sort of accounts should you use, and how should you prioritize them?
For starters, perfect is the enemy of good. If you worry too much about the tiny details, you might feel too overwhelmed to even begin your savings journey, and that's not what you want. So take this overview as a rough guide, but don't worry too much about having the perfect strategy — any saving for the future is better than inaction, regardless of how you go about it.
That's to say… taxable accounts versus tax-advantaged accounts. Taxable accounts are great if you've already contributed the maximum allowable amount to your tax-advantaged accounts, or if you're saving for a specific goal and are going to need the money before you'd be able to access the funds in your tax-advantaged accounts.
But tax-advantaged accounts are a powerful tool when it comes to saving for your future, and they're what we're going to focus on today. Depending on the account, you'll either avoid paying taxes on the contributions or on the withdrawals — or both, in the case of health savings accounts (HSAs).
And tax-advantaged accounts also let your money grow tax-free over time, which means you could end up with a lot more money in the account once you eventually withdraw it, even if it's an account that requires you to pay income tax on the withdrawals.
Most tax-advantaged retirement accounts let you avoid paying income taxes on your contributions, but then require you to pay income taxes on your withdrawals. Roth accounts take the opposite approach: Contributions to Roth accounts — including Roth IRAs, Roth 401(k)s, and Roth 403(b)s — are made with after-tax funds, but then you don't have to pay taxes on the withdrawals. In both cases, the money grows tax-free over time.
And then there are HSAs, which offer the best of both worlds: Your contributions are pre-tax, there are no taxes on growth in the account (which can be interest or investment gains), and the withdrawals are also tax-free as long as you're using them to pay qualified medical expenses (which can be current expenses or expenses that you incurred at any time since you established your HSA).
HSAs can be used as a backup retirement account too: If you wait until you're 65, you can pull money out of your HSA for whatever reason you like, although you'll pay income taxes on the withdrawals if you're not using them for qualified medical expenses.
So should you prioritize your HSA or your retirement account? With this question, keep in mind that there are a wide range of retirement accounts available. To keep things simple, we'll refer to the 401(k) from here on, but know that there are lots of other tax-advantaged retirement accounts that might be an option for you.
In an ideal world, you'd contribute the maximum allowable amount to your retirement account(s) and your HSA. But very few people have the resources to do that. So here are some things to keep in mind when you're deciding which account to fund or how much to allocate to each account:
1. Is your employer contributing to your 401(k) or your HSA?
And is it a matching contribution? If so, you'll probably want to contribute at least enough to each account to get the full employer match. That's free money that you'll otherwise be leaving on the table.
2. What's your retirement time frame look like?
Money in your 401(k) can be withdrawn without a penalty once you turn 59 and a half. But if you're also planning to use your HSA as a retirement account, keep in mind that you have to wait until you're 65 before you can start withdrawing money from your HSA for non-medical expenses (in both cases here, you'd pay income tax on the withdrawals, but no additional penalties).
But if your plan is to use your HSA money to pay for medical expenses — as opposed to general retirement expenses — you can withdraw it at anytime without paying taxes on it.
3. Consider the contribution limits
For 2021, you can contribute up to $19,500 to your 401(k), plus another $6,500 if you're at least 50 years old.
HSAs, on the other hand, have a contribution limit of $3,850 in 2023 if your HSA-qualified health plan covers just yourself, and $7,750 if it covers at least one other family member. Those contribution limits include total combined contributions from you and your employer — or anyone else who wants to contribute to your account. And although there is an option to make a catch-up contribution of up to $1,000, it doesn't start until you're 55 years old.
4. Do you expect to have significant medical expenses in the near future?
If so, funding your HSA is probably a wise choice, as you'll have a stash of tax-free money available to pay your out-of-pocket medical expenses. There are ways to access your 401(k) money before age 59.5 if you need it to pay medical bills, but it's much more straightforward if you have the money in an HSA instead.
5. Do you have a plan for long-term care expenses?
You may have already purchased — or plan to purchase — private long-term care insurance. But Medicare does not cover long-term care, and although Medicaid does, it only does so after you've exhausted your assets.
Money from your 401(k) or HSA can be used to fund long-term care expenses, but you'll be able to take it out of your HSA tax-free, since the cost of long-term care is a qualified medical expense.
6. Do you have a plan for covering medical costs before you need long-term care?
Again, you could use your 401(k) funds for this, but you'd have to pay income tax on the withdrawals, assuming it's not a Roth account. On the other hand, if you've been growing a stash of money in your HSA for a few decades, you'll have access to tax-free funds that you can use to pay your medical bills in retirement.
There's really no right or wrong answer when it comes to how you prioritize your savings, with the caveat that it's almost always a good idea to contribute enough to get whatever matching contribution your employer is offering. And the triple tax advantage of HSAs (tax-free contributions, tax-free growth, and tax-free withdrawals for medical expenses) is hard to beat.
But the right approach for your situation won't necessarily be the same as someone else's. As always, it's a good idea to consult with a tax adviser if you want specific advice and guidance.
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