There are many different kinds of retirement investment accounts out there, each with their own pros and cons. Unfortunately, many people can't afford to max out all of them each year, which can leave them with tough choices about where to put their investment dollars.
While the first thing to do is always to earn any employer matching funds in a 401(k), you'll have decisions to make about what to do with any extra savings. If you find yourself in this situation, there's one particular account I'd prioritize above all others. Here's what it is.
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Focus on maxing out your HSA before other retirement plans
To me, the choice is simple when it comes to which retirement investment account to prioritize after maxing out a 401(k) match. Without question, it's a health savings account (HSA).
Now, you may be surprised to hear that, since an HSA isn't technically a retirement account. It's intended to help people with high health insurance deductibles cover medical costs. And you must have a qualifying high-deductible health plan to contribute to an HSA, which many people don't have.
But if you're eligible for an HSA, it has some significant advantages that make it an ideal way to save for retirement. Here's what they are:
- You can contribute money with pre-tax funds. You reduce your taxable income each year based on the amount of contributions you made. The government subsidizes your investment when you do this, since contributions you make don't reduce your take-home income as much. For each $1,000 contributed to an HSA, you save up to $220 on your taxes, assuming you're in the 22% tax bracket.
- Money grows tax-free and can be withdrawn for qualifying medical expenses tax-free. When you withdraw money from an HSA to cover qualifying medical expenses, you aren't taxed on the withdrawal.
- HSA money isn't use-it-or-lose it. Unlike with a Flexible Spending Account (FSA), you aren't required to spend the money in your HSA within any specific period of time. You can keep it in your account indefinitely for years on end if you want.
- HSA money can be invested. HSA accounts typically allow you to invest the contributed funds, although your account may need to have a certain amount of money in it to do so.
Because of these four features, you have the option to make deductible investments in an HSA up to annual contribution limits, invest it for the future, and get a triple tax benefit. There's no other retirement account that provides tax-deductible contributions and tax-free withdrawals. Most require you to choose an up-front tax break (available for traditional IRA and 401(k) accounts) or a deferred tax break (available for Roth accounts) but not both.
What about the rule that you need to use the money for qualifying medical expenses?
Now, you may be wondering about that rule stipulating that you can withdraw money tax-free only to pay qualifying medical expenses. This might make the account seem like it's not ideal for retirement savings, since you'll likely need your retirement funds to cover lots of different expenses.
The reality, though, is that estimates suggest a senior couple turning 65 in 2021 could end up spending around $300,000 to cover out-of-pocket medical expenses during retirement. Since medical care will probably take up a huge chunk of your retirement budget, chances are good you'll use a lot 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 in it from contributing enough to earn your employer match.
HSAs also allow you to take money out without penalty for any purpose after age 65 -- although you do need to pay taxes 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 extra 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'd focus on maxing out first after earning any available 401(k) match.
