Is a 401(k) the best employer-offered retirement account?

It’s often said that a 401(k) is the best employer-sponsored account to help employees save for retirement. But if an employee only had $1 to save, is the so-called gold standard of retirement savings really the best place to start? Well, maybe not…

First and foremost, addressing retirement savings is one of the most important steps to take. Maximizing those savings is the next step. Even with this strategy, most Americans face a dramatic retirement gap in their current savings (the amount employees have saved vs. the projected amount they need for household expenses in retirement). Traditional savings vehicles are no longer sufficient to ensure employees don’t outlive their savings. It’s a huge problem, and COVID-19 is making it even worse.

With this understanding we need to answer two questions: Where should employees start, and what more could they and their employers do?

Should 401(k)s be the gold standard for retirement?

Today, the most popular retirement vehicle is the 401(k). It dominates other employer retirement offerings as a quick and easy way to save for retirement, due to strong employee education and familiarity. What you might not know is that a 401(k) was not supposed to be a single source of retirement savings when it was introduced to the market in 1980. But misperceptions about the 401(k) are part of the reason for the existence of a clear and growing retirement gap in the US. The IRS recently released the new 2021 401(k) contribution limits of $19,500 (no change from 2021). Catch up contributions also remain at $6,500.

What should be considered is the ‘why.’ 401(k) adoption grew because of the clear tax-benefits and dedicated savings they offer for retirement.

• Employers like 401(k)s because they are well known, easily understood and are already integrated into their payroll providers. It’s the most cost and time-efficient way to offer a retirement benefit.
• Employees like 401(k)s because they can automatically save pre-tax money for retirement. It’s set and forgotten and easy to see their savings grow on their mobile phones. An employer contributions match sweetens the offer.

But by understanding the retirement gap outlined above, we know the current retirement offering is insufficient for employees. Employees need more options or ways to save for their retirement.

The stealth 401(k) for health care

Let’s get to it: there is another way to save tax-free for retirement. A health savings account (HSA) is designed to help account holders set aside money on a pre-tax basis to pay for qualified medical expenses. Employees can use those funds for qualified medical costs today, or for years to come.  Because those funds never expire, they can grow tax-free well into retirement, just like a 401(k).

What is different from a 401(k) is that an HSA does not require minimum distributions. After the age of 65, account holders can use HSA funds just like a 401(k) and pay standard income taxes. They can also continue to pay for qualified medical costs, tax-free.

In 2021, employees can contribute $3,600 to an HSA for individual coverage and $7,200 for family coverage. You can read about HSA-eligible requirements here. The HSA might not have been designed to compete with the 401(k), but the reality is that it offers equal if not better tax-saving benefits when compared to the 401(k).

Prioritize health care in retirement

The argument that HSAs should complement or supersede 401(k)s as the first-dollar retirement savings is based on two factors: tax-savings and flexibility. 401k(s) and HSAs both have tax-free contributions and growth. On top of that, HSAs offer no required minimum distributions and tax-free distributions for qualified health expenses.

Unlike 401(k)s, HSA savings can be used this year for qualified medical expenses or saved for years to come. That flexibility offers employees more financial planning options.

Based on this new way of evaluating these two types of retirement accounts, HSAs clearly offer more advanced savings options for retirement, with a health care savings bonus. Based on that, employees should prioritize saving and max out their HSA contributions yearly, unless their employers offer 401(k) match, in which case, they should start with their 401(k) and move to their HSAs. The goal is to get employees the most savings at the lowest tax-cost.

The reality is that employees need to save more for retirement. When considering the retirement gap, it’s also important to understand that the average couple can expect to pay $295,000 in retirement in out-of-pocket costs on top of expected Medicare coverage. Employees need both a 401(k) and HSA to plan for costs in retirement.

The only other considerations are investment minimums and fees. They can delay or detract from an employee’s savings potential. Employers should evaluate these savings obstacles and educate employees of the long-term financial impact they have.

The gold standard — a good provider, a 401(k), and an HSA — will make all the difference in enrollment and contributions. A good provider, both 401(k) and HSA will make a difference in enrollment and contributions as improved education will lead to a direct increase here.

On top of that, employers should consider presenting the HSA before health care selection as HSA-eligibility (and thereby contributions) are controlled by health plan selection. This will take time. But the results will be an overall better understanding of tax-advantaged retirement savings options. No matter where employees get started, employers can and should help them understand the need for more than one retirement plan.

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.