How to use health care to fund retirement: Building a retirement savings bundle with a 401(k) and HSA in open enrollment

When you are worried about today, preparing for tomorrow is hard to manage. But like many things in your life, health care planning can never start too soon. You feel the impact when you pay for a prescription at the pharmacy or schedule a doctor’s appointment over the weekend. It’s one decision that splashes out across your personal finance and lifestyle options.

Health care is an annual consideration, but if you only think about your health care annually you are missing a major factor; your health care decision affects how much tax-free money you can save for retirement. It might not only change your approach to health care coverage, but also how you save for retirement.

Open enrollment ready

Getting ready for open enrollment should include using your past open enrollment success to set up your future benefits selections. Start by reviewing your current benefits.

Then, forecast your expected costs and note any lifestyle changes or any new benefits requirements or costs.

Finally, compare your health plan offerings to build the most personalized health coverage. Don’t overpay, but don’t skip out on the coverage you need. This will give you a leg up for all required open enrollment selections — but it only solves the next 12 months.

In addition to out-of-pockets costs for this year, you need to consider out-of-pocket expenses for retirement. Health care is not an annual experience, it’s a lifetime expense. You need to prepare for out-of-pocket health care costs this year and those expected in future years. The average couple can expect to pay $295,000 in retirement in out-of-pocket costs on top of expected Medicare coverage. It’s time to prepare for those costs, so your health care expenses don’t steal your retirement savings.

The retirement gap

Saving for retirement often takes a backseat to expected financial obligations. Out-of-pocket health care costs are at the top of that list. This is one contributing reason that we have a widening retirement gap in the United States.

The retirement gap is the difference in funds that the average American has saved vs. what they need. This includes both personal savings (e.g., 401(k)s, pensions) and social security. As lifespans increase, traditional savings vehicles are no longer sufficient to ensure people don’t outlive their savings. It’s a huge problem, and COVID-19 is making it even worse.

The new estimate forecasts that nearly half of Americans over 55 will retire in or near poverty. Unfortunately, there is no fix-all solution. Americans need help today.

Those who can save more, should save more, all tax-free. This is where Health Savings Accounts (HSAs) can help. Not only are they 100% tax-free, they give individuals the flexibility to choose to use those funds for healthcare expenses today or keep those funds for retirement.

There are other retirement options available on top of 401(k)s and IRAs, like an HSA. Don’t settle for one account, when you can have a few, with more flexibility. Choice is hard to find when it comes to tax savings. The peace of mind alone might be enough, but the additional tax-free savings is extraordinary.

HSAs: The secret retirement weapon

Your health plan selection directly impacts your HSA-eligibility, and therefore your ability to save pre-tax health care dollars. What is an HSA? An HSA is an easy and smart way to pay for qualified medical expenses for the account holder and their dependents. It’s owned by the individual and is theirs for life, with no expiration date on those funds.

Think of an HSA like a 401(k) for health care, with an extra tax benefit. An HSA can be used to pay for health care costs today, in the future, or used as a savings vehicle for retirement.

HSAs are the secret retirement weapon you might have been missing in your retirement plan. You can save and spend those funds for health care costs today or in the future.

Consider this quote: “In fact, rather than spend down your HSA each year, you can let the HSA grow – tax free. You can even save those receipts that you previously paid, and reimburse yourself later when tax free income is most meaningful (perhaps that is at retirement). Imagine this, if you were to contribute $1,000 a year to your HSA, leaving the balance to grow, from age 30 to age 64, you would have a balance in your HSA of $183,989 assuming you had an investment return of 6%. This creates an account that you can use to spend on those unreimbursed health care expenses not covered by Medicare (and you even can use it for Medicare premiums),” Karin M. Rettger, AIF, President and Founder of Principal Resource Group (PRG).

Once you turn 65 years of age, you can use your HSA funds for anything, just like your 401(k). The flexibility of this IRS-regulated savings account might be surprising, but it gives you a new tax savings option to double down on your retirement needs. In fact, the same dollar in your HSA can extend out longer than in your 401(k) due tax-free savings on qualifying health care expenses.

The resulting impact of combined 401(k) and HSA savings with their respective tax savings is a 42% increase in savings over 20 years (vs. 401(k) only savings). The combined average savings is also much larger than when an individual saves for a 401(k) or HSA only.

HSA vs. 401(k): Understand the differences

The value of each tax-advantaged savings account is measured not only in the tax savings but also in the flexibility in savings, spending and growth. All of these factors weigh into the savings impact of the accounts. Simply put, where do you get more for each dollar you put in?

1. Contribution limits – In order to contribute to a 401(k) or an HSA (pre-tax) these benefits must be offered by an employer. Individuals can still contribute to an HSA, tax-free, and claim the tax deduction at year-end if they can’t get an HSA through their employer.

In 2020, 401(k) contributions are capped at $19,500. In 2020 HSA maximum contributions are $3,550 for individuals and $7,100 for families. In 2020, 401(k) catch up contributions (50+) are $6,500 and for HSAs they are $1,000 (65+).

2. Flexibility – Both 401(k)s and HSAs allow you to save pre-tax money for retirement. The biggest difference in these accounts is that you can also use your HSA for qualified medical expenses. From the day you establish your HSA you can save or spend those funds. An HSA gives you more spending options with the retirement savings power of a 401(k).

3. Distributions – One difference between the 401(k) and the HSA is required minimum distributions (RMD). Unlike a 401(k), an HSA has no mandatory distributions in retirement. You get to decide when and if to use those pre-tax assets or sell investments in your HSA well into your 70s, 80s and 90s.

From a tax savings perspective, the value of both accounts is tremendous. Just as importantly, they both create dedicated funds for retirement, which ensures those funds are there when you need them. You can clearly contribute more to a 401(k) than an HSA, so where should you start?

Where to put your first dollar?

It sounds complicated, but start by considering the two most important factors—employer 401(k) match and potential tax savings.

1. If your employer matches your 401(k), start there.
2. If not, the flexibility and tax-savings of an HSA outweigh a 401(k).

Regardless of where you put your first dollar, it makes sense to have funds in both accounts; it should not be one or other. Remember to consult a tax or financial advisor to understand the right amount to contribute to each account.

The only caveat here is to take note of fee schedules and administrative costs from your HSA and 401(k) providers. These fees can dramatically impact your savings over the life of your account.

Can I open an HSA?

In order to contribute into an HSA, you must be covered on an HSA-eligible health plan, like a high deductible health plan (HDHP). You can read full eligibility details here for 2020.

Tax-free savings isn’t as easy as we want it to be. It’s crucial that during your yearly open enrollment selection, you enroll in a HSA-eligible health plan if you want to contribute to an HSA. It will not only impact your healthcare savings this year, but for years to come. Your healthcare selections directly impact your retirement savings.

If you want to properly prepare for retirement and cut down or avoid your personal retirement gap, the priority is not an HSA or 401(k), it’s both. Coupling an HSA and 401(k) not only provides the long-term saving you need for retirement, but adds the flexibility and short-term benefits of tax-free health care spending.

The only mistake is not considering an HSA to help add depth to our retirement savings. Start this year, so you are ahead for retirement.

Final note: If you already have an HSA-eligible health plan, you can add an HSA at any time, no need to wait for open enrollment. By understanding the last month rule you might be able to jumpstart your savings by adding a full-year contribution for 2020 and start 2021 with an established HSA nest egg.

Shobin Uralil is the COO and Co-Founder of Lively.

Disclaimer: the content presented in this article is for informational purposes only, and is not, and must not be considered tax, investment, legal, accounting or financial planning advice, nor a recommendation as to a specific course of action. Investors should consult all available information, including fund prospectuses, and consult with appropriate tax, investment, accounting, legal, and accounting professionals, as appropriate, before making any investment or utilizing any financial planning strategy.