There are different types of savings accounts you might have access to that offer unique tax benefits. If your employer sponsors a 401(k) plan, you can enjoy tax-free contributions and tax-deferred growth in a traditional 401(k), or tax-free growth and tax-free withdrawals in a Roth 401(k).
Meanwhile, if you have a health savings account (HSA), you can enjoy three types of tax savings in the course of socking money away for healthcare spending. HSA contributions are tax-free, investment gains are tax-free, and withdrawals are tax-free, as long as they're used to pay for qualified medical expenses.
If you have both a 401(k) plan and an HSA, you may be wondering which one to prioritize. The reality is that funding both plans is a good bet if you can. But if your 401(k) comes with one key feature, you may want to put it ahead of your HSA.
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When there's free money to be had
You might assume that your 401(k) plan should take priority over your HSA because it can be used for any purpose once you reach retirement age, whereas an HSA can only be used for healthcare spending. But that's actually not true.
If you're under age 65, there can be steep penalties for taking an HSA withdrawal for non-medical purposes. But once you turn 65, those penalties go away.
As mentioned earlier, HSA withdrawals are only tax-free when used for medical expenses. So if you're 65 years old and take a $5,000 HSA withdrawal to fix up your home or take a trip, you won't face a penalty -- but you will pay taxes on that $5,000. But in that case, you're in the same situation you'd land in with a traditional 401(k) withdrawal.
The reason you may want your 401(k) plan to take priority as far as your money goes is that many companies that sponsor these plans also match employee contributions, to some degree. If you have an opportunity to snag that free money, it pays to go for it.
If you pass up an employer match, you'll lose out on more than just a sum of money. You'll also lose out on the opportunity to invest that money and grow it into a larger sum.
Let's say you're able to carve out $5,000 this year for savings purposes, and your employer will match up to $3,000 in 401(k) contributions. In that case, it makes sense to fund your 401(k) with that $3,000, and then think about putting the remaining $2,000 into your HSA.
But if you're not eligible for an employer match, the decision could go either way. And you could argue that prioritizing your HSA makes more sense since that account comes with more tax benefits than a 401(k) plan (either type) and can basically function just like a traditional 401(k) once you turn 65.
Ultimately, the more money you're able to sock away for retirement and healthcare needs, the better. But if you're limited on contributions, think about which account will offer more financial upside all in.
