Is it better to contribute to a 401k or an HSA?

Husband is maxing out his 401k. I’m contributing just enough to get my company’s match. Time to re-evaluate health insurance. Is it worth opening up a HSA or should I contribute more to my 401k? Thanks!!

- Kayla

Hey Kayla,

The ultimate uses of a 401(k) or Health Savings Account (HSA) may seem like they are competing against each other, but in reality, that might not be the case for everyone. I can hear you thinking already, “how is he going to answer my question by starting like this?” I will, Kayla. I will.

First, a quick reminder as to why HSAs are amazing. First, and most notably, any contribution to an HSA is triple tax advantaged. The contributions themselves aren’t included in your taxable income (that’s #1). The contributions then grow tax deferred inside the HSA (that’s #2). And, if the money is then used for a qualified medical expense, the money can be withdrawn tax free in the future (that’s #3)! That’s a good deal in anyone’s book. Furthermore, you don’t have to use your contributions in the year they’re made, even if you have healthcare expenses that same year. You could keep contributing money year after year until you retire and never touch the balance. Hmmm… Hold on to that thought.

What’s the catch? You have to pair a HSA with a High Deductible Health Plan (HDHP). In other words, you’re going to have to pay more out of pocket before your insurance kicks in to help you out. The good news is that high deductible plans often have monthly premiums that are noticeably easier on the pocketbook than their traditional plan siblings. “Great,” you’re thinking. “I can use that extra money every month to pay for my Noodlpolitan membership.” Not so fast, my friend. It would be a wise move to take the difference in cost between a traditional health insurance plan and a HDHP and contribute that to the HSA.

“But, Noodlpolitan…,” you sigh.

I know, Kayla. But ramen is high in sodium and I’m actually doing you a favor. You’ll thank me someday when your blood pressure is normal and you’re sitting on a fat HSA.

But, you didn’t email us so I could explain HSAs and crush your ramen dreams, did you? Should you take the HDHP/HSA combo and invest the premium savings into your 401(k)? Well, let me toss a suggestion out and see what you think.

If your family is pretty healthy and don’t have many healthcare expenses during the year, don’t put the difference into your 401(k), stuff it into your HSA like I suggested. If you can do that, and use it sparingly until you’re retired, you’ve essentially created an account that you can use to pay for your medical expenses in retirement. That means you won’t have to rely on your other streams of retirement income to pay for 100% of your out of pocket healthcare expenses. Those out of pocket expenses are projected at being around $250,000 per person in retirement, by the way. Yeah…

Why else is this worth considering? A HSA gives you another account you can contribute to besides your 401(k) with different contribution limits. Hopefully, you get to the point where you can max out your 401(k). If you can do that and contribute to a HSA, you’re able to save an even greater amount of your income. Doing this will increase your Power Percentage quite nicely. Why is a high Power Percentage important? And, what the heck is a Power Percentage, anyway? Check out what Pete has to say on Episode 120 of his show on this very topic.

So, what should you do? I think you and your husband should seriously consider the HDHP/HSA option if your family’s health needs permit it. It gives you the option to save money in a different type of account to be used specifically for future health needs and the ability to do it on a very favorable tax basis. Making the leap from a traditional health insurance plan to a HDHP/HSA may take a few adjustments (emergency fund, budget, etc…). If you can make it work, however, you will have a significant advantage at your disposal.