If you ask someone what the best retirement account of all time available to us today is – you will get varying answers. There are Roth and Traditional IRA’s, 401k’s, 403b’s, solo 401k’s, and SEP IRA’s. However, in my view, the king of retirement accounts isn’t on that list. The account is often overlooked and many who can, simply do not take advantage of it. I myself didn’t grab the benefit of this account for three years of my working career. I am talking about a Health Savings Account (HSA). Unfortunately, not everyone is able to open one – you must be in a high deductible health care plan to even qualify.
The benefits of an HSA are truly mind-blowing! First off, the account is triple tax advantaged. You do not pay income tax (even FICA, 7.65% at this writing) on the dollars going into an HSA. Money will grow tax free in the account (each HSA has investments available to it). Finally, money can be withdrawn, tax-free, if the expense is for a medical reason. One other thing, at age 65, the IRS allows you to withdraw from the account penalty-free, as if it were a 401k – you will simply pay income taxes.
So, let’s run some numbers. Joe and Bob are each 30 years old, Joe decides to max out his HSA every year, until he turns 65 ($3,400 per year). Bob decides to increase his pre-tax 401k savings by the same amount until he turns 65. Joe simply places his $3,400 into his HSA, as he will owe exactly $0 in taxes. Bob, however, must first pay the FICA tax on his pre-tax contributions – 7.65%. That means, each year, he only contributes $3,140 (out of his original $3,400).
In 35 years, their account balances look like the following:
Let that sink in a moment. By simply changing where Joe is putting his money – he gets an additional $44,819! There are two reasons for this. First, Joe is getting 7.65% extra principal due to not having to pay FICA on his contributions. Second, time and compound interest are working on that extra 7.65% principal.
The benefit of an HSA doesn’t stop with the contributions though, remember that you can withdraw from an HSA for medical expenses at ANY time tax-free. A wonderful side-benefit of the HSA is that after age 65, you can pay many health insurance premiums tax-free from the account. Let’s assume that Joe and Bob choose the same medical insurance coverage. Current average healthcare coverage costs are about $536 per month, or $6,432 per year. After age 65, Joe will pay these premiums out of his HSA, tax-free. Meanwhile, Bob will pay these premiums out of his 401k. Both Bob and Joe will withdraw $50,000 as their annual income from retirement accounts, placing them into the 25% marginal tax bracket. This means their effective FICA + Federal tax rate is 18.74%. As such, in order to cover the health insurance premiums for medicare, Joe will need to withdraw $6,432 from his HSA (remember no taxes). Bob will need to withdraw $7,637 from his 401k to cover income taxes and the premiums. What will their account balances be after 20 years, assuming average market returns (8%)?
Joe’s HSA balance is $268,457 larger than Bob’s! No taxes and the initial principal increase of 7.65% have paid dividends to Joe in spades! Keep in mind, the chart above assumes $0 in medical expenses aside from premiums. If you account for the average medical spending of someone aged 65+ ($1,362 / year), the difference is even more stark.
Again, if Joe decides to, at this point (age 65+) he can withdraw from his HSA as if it were a 401k. So, not only does he have an increased balance, but he has an increased balance that can be used in the same manner as Bob, just with lots of extra benefits.
These are the reasons that I think the Health Savings Account is the secret king of retirement accounts. What do you think?