The most common non-pension-related practice while saving for retirement typically involves a 401(k) and an individual retirement account (IRA), but a health savings account (HSA) could be a great supplement and may actually provide more benefits to certain savers than an IRA.
Let’s take a closer look at how IRAs and HSAs work, and the pros and cons of using one over another.
Contribution Limits of IRAs vs. HSAs
The first thing to know about an IRA is that you have to have earned income to actually be able to contribute to this type of account. IRS rules block contributions from dividends or interest, income from deferred compensation plans or any rental income.
Contributions made to either traditional IRAs or their Roth variants are limited to $6,000 per year, or $7,000 if you are at least 50 years old. Rollover contributions and qualified reservist repayments do not count toward this limit.
Thanks to the Secure Act that passed into law last year, there is no longer an age limit attached to making contributions. So you can keep throwing money into an IRA as long as you keep working.
Money within an IRA grows tax-deferred.
Contributing to an HSA is tax-free or tax deductible, but the important thing to know is that you must have a qualifying high-deductible health insurance plan to be eligible for an HSA.
As of 2020, contributions into an HSA are limited to $3,550 per year for an individual, and $7,100 if enrolled in a family plan.
Many companies that offer HSAs will also offer an employee match similar to 401(k)s, and any amount contributed by your employer does not count toward your taxable income.
One important thing to know about HSAs is that you can no longer contribute once you enroll in Medicare Part A and/or B. You will still be able to use the funds within the account, though.
Money within an HSA also grows tax-deferred.
Withdrawing Funds from IRAs vs. HSAs
While there isn’t an age limit for contributing to IRAs while you continue to work, you do have to worry about required minimum withdrawals (RMDs). The Secure Act raised the age that you must start making RMDs to 72, but that still means you can’t just let the money sit in your account until needed later down the road. If you don’t start making RMDs by April 1 of the year after you turn 72, you may be hit with an excise tax.
Distributions made before you turn 59 1/2 may also be hit with an additional 10% tax, according to the IRS.
One thing of note is that a lot of these rules do not apply to Roth IRAs.
Per The Balance:
These rules apply to traditional IRAs, not to Roth IRAs. Contributions to Roth accounts aren’t tax deductible, but the money isn’t taxed upon withdrawal, either, as is the case with traditional IRAs.
Funds within an HSA can be withdrawn tax-free if used to pay for qualified medical expenses, which makes the account a great savings option for future health expenses because of the account’s tax avoidance qualities.
After age 65 HSA funds can be used to pay for health care premiums, and that even includes Medicare Part B premiums and premiums for long-term care insurance.
Before 65, HSAs can only be used for other qualified medical expenses like co-pays, dental care or deductibles.
The account can even be used to pay for other things, but those transactions will incur a hefty 20% tax penalty. On top of that, the IRS considers funds used this way as taxable income, so you would have to suffer another hit when you file your taxes.
The good thing to know is that after 65, the IRS waives the 20% penalty for nonmedical expenditures.
Rolling Over Funds in IRAs vs. HSAs
You can actually perform a one-time, tax-free transfer from an IRA to an HSA, but the amount transferred does count toward that annual contribution limit stated above. It can help move a small amount of money over to your HSA to pay for surprise medical expenses tax-free.
Funds can’t be transferred from an HSA to an IRA, which makes sense given the purpose of an HSA.
Another good thing to know about HSAs is that it does not go away when you leave your job or retire. Funds within an HSA can be invested, but you will need to check with your provider for how to do so because each provider has certain investment thresholds that must be met. For example, you might be able to invest funds over a certain threshold, such as $1,000.
And you can transfer funds from one HSA to another, which is probably easiest to do by asking your current provider to do a “trustee-to-trustee transfer.” This can be helpful when leaving one job for another that has a better HSA provider, or if you want to work with another financial institution.
We’ve been harping on the benefits of HSAs for the last couple of days here on Money and Markets, but using an HSA in tandem with other retirement accounts (or even by itself) can be a huge boon for your savings goals.