If I could only max one investment account, it would be this one.
There are many types of investment accounts for retirement, each with its pros and cons. Unfortunately, many people can’t afford to max them out every year, which can leave them with tough choices about where to invest their money.
While the first thing to do is always to earn employer matching funds in a 401(k), you will have decisions to make about what to do with any additional savings. If you find yourself in this situation, there is one particular account that I would favor above all others. Here is what it is.
Focus on maxing out your HSA before other retirement plans
Now, you might be surprised to hear that, because an HSA is not technically a retirement account. It is intended to help people with high health insurance deductibles to cover medical expenses. And you must have an eligible high-deductible health plan to contribute to an HSA, which many people don’t have.
But if you qualify for an HSA, it has significant benefits that make it an ideal way to save for retirement. Here is what they are:
- You can bring cash with pre-tax funds. You reduce your taxable income each year by the amount of contributions you have made. The government subsidizes your investment when you do this, since the contributions you make don’t reduce your net income as much. For every $1,000 paid into an HSA, you save up to $220 on your taxes, assuming you are in the 22% tax bracket.
- The money grows tax-free and can be withdrawn for eligible medical expenses tax-free. When you withdraw money from an HSA to cover eligible medical expenses, you are not taxed on the withdrawal.
- HSA money is not to be used or lost. Unlike a Flexible Spending Account (FSA), you are not required to spend your HSA money within a specific time frame. You can keep it in your account indefinitely for years if you want.
- HSA money can be invested. HSA accounts generally allow you to invest the paid-in funds, although your account may need a certain amount of money to do so.
Because of these four features, you have the ability to make deductible investments in an HSA up to annual contribution limits, invest it for the future, and get a triple tax benefit. There is no other retirement account that offers tax-deductible contributions and tax-free withdrawals. Most require you to choose upfront tax relief (available for IRAs and traditional 401(k) accounts) or deferred tax relief (available for Roth accounts), but not both.
What about the rule that you must use the money for eligible medical expenses?
Now, you might be wondering about that rule that says you can only withdraw money tax-free to pay for eligible medical expenses. This might give the impression that the account is not ideal for retirement savings, as you will likely need your retirement funds to cover many different expenses.
The reality, however, is that estimates suggest that an elderly couple turning 65 in 2021 could end up spending around $300,000 to cover medical expenses during retirement. Since medical care will likely take up a significant portion of your retirement budget, chances are you’ll be using a large chunk of your HSA money to pay for care as a senior. You can reserve your HSA for these costs and cover other expenses using Social Security or distributions from your 401(k), which should have money contributing enough to earn your employer’s match.
HSA Also allow you to withdraw money without penalty for any purpose after age 65 – although you will pay tax at your ordinary income tax rate in this scenario. So the worst that happens is that HSAs are taxed like 401(k)s, and the best case scenario is that you get an additional tax benefit by investing in them.
Because of these special HSA rules, health savings accounts are definitely my priority for retirement savings and are accounts I would focus on first after getting any available 401(k) matches.