Why Health Savings Accounts may be a better retirement plan than a Roth IRA

By Paul Feldman

By Kevin R. Clark

Financial planners have long considered funding Roth IRAs and Roth 401(k) to be the preferred vehicle of saving for retirement, and rightfully so.

Since Congress authorized the Roth account as a savings option in 1998, it has demonstrated the potential for massive tax benefits. A Roth account, like all IRAs and 401(k) plans, includes a tax deferral benefit – meaning that as long as money stays within the account and is not withdrawn, an investor is not obligated to pay annual taxes on interest, dividends and capital gains earned.

However, the far more potent benefit of a Roth is its potential tax-free status. By inverting the tax treatment of traditional IRAs, a Roth account holder can pay taxes today in exchange for the potential to withdraw all accumulated and untaxed earnings in retirement with zero taxes owed.

For younger investors and families with modest income, the Roth has almost become a default first option for long-term saving. Wealthier individuals with shrewd tax advisors, who would normally not qualify to save to a Roth, have also in recent years prioritized legally funding Roth accounts through a strategy affectionately known as “backdoor Roth contributions;” the proliferation of people using this tactic has caused some Congressional representatives to explore eliminating the strategy.

Another vehicle

Yet many planners are unaware that another savings vehicle, introduced six years after the Roth account, may offer their clients even more desirable tax advantages: the often-misunderstood and frequently-underutilized Health Savings Account. These accounts offer the same advantages of a Roth (tax deferral and potentially tax-free withdrawals of earnings), while also permitting contributions to be deducted from income for federal tax purposes.

Unlike a traditional IRA, there is no income limitation at which the deduction can be reduced or eliminated. No other savings vehicle allows this triple tax benefit. Additionally, 47 states have also aligned their tax codes to match the federal treatment; the remaining holdouts include California, New Jersey, and New Hampshire, with the last of these recently passing legislation that will align it with federal tax law by 2026.

There are of course some strings attached. Notably, qualifying to contribute to an HSA requires that an investor be covered only by a high-deductible health plan (as defined annually by the IRS), with no non-HDHP secondary coverage. This disqualifies those enrolled in Medicare, eligible for military Tricare, and married individuals covered by a spouse’s non-HDHP insurance.

The HSA also has a lower annual limit on what can be contributed than both a Roth IRA and Roth 401(k), and many providers of these accounts impose limitations on how funds can be invested as well as how much of the account must remain in cash, effectively preventing an investor from earning a positive real return on a portion of their funds.

The other noteworthy requirement is that tax-free withdrawals require that the money either be to pay for qualified out-of-pocket health expenses, or to reimburse the investor for out-of-pocket costs they paid in prior years. The implications of that last part are what make this account potentially more valuable than a Roth as a retirement savings tool.

Investors who keep diligent records of what they paid during their working years for healthcare costs may take lump withdrawals from their HSA in retirement, completely tax-free if they are matched to out-of-pocket expenses. Failing to use the funds for healthcare or being unable to provide documentation of past spending, however, can subject the HSA owner to taxation on the full amount of a withdrawal as well as a punitive 20% tax penalty if the withdrawal is done before age 65.

One last consideration

The last consideration is that it behooves an HSA owner to empty their account, or to designate their spouse as beneficiary, prior to passing away. If a non-spouse inherits an HSA balance, the full HSA balance must be included in the inheritor’s taxable income. For single clients who will not incur large out-of-pocket costs throughout their life, or who have family histories of premature death, it is important to weigh this and not overfund the HSA, as it can become highly tax-inefficient in the event of an early passing.

In summation, HSAs differ significantly from Roth accounts, and they are not for everyone. It is important to assess with your client not just whether they are eligible, but whether the higher out-of-pocket costs associated with a HDHP could be absorbed in the event of a health emergency.

Nonetheless, for certain young, healthy, or single clients, there may be merit to funding an HSA prior to a Roth account for long-term investing towards retirement.

Kevin R. Clark is a Financial Advisor at Highview Advisor Group, a private wealth advisory practice of Ameriprise Financial Services LLC, and the owner of Arch City Tax Services LLC. He is the 2022 FPA NexGen President.

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