HSA Optimization
Personal finance isn’t exactly cool. It’s generally not a topic that people enjoy talking about at dinner parties. You will not have children commonly saying they hope to grow up and work as an accountant or a financial advisor. That being said, we here at The Financial Planning Co. think personal finance is fascinating, almost regardless of the sub-topic. Term vs. permanent life insurance debate? Sign us up. Capital market projections discussion? Yes, please and thank you. After the topic of hot stocks, the crème de la crème of personal finance topics is HSA optimization. It combines the best of tax efficiency, legal loopholes, and rarity of awareness. If you’re using your HSA in an optimal way, as a retirement savings vehicle, you’ll instantly earn our respect.
So let’s learn about how and why the HSA can be such as awesome retirement savings vehicle. Here are the instructions.
1.) Contribute - if eligible - to the HSA at the maximum allowed.
2.) Invest your HSA assets. Seek a company that allows you to do what is called first-dollar investing, meaning they don’t require a cash balance first. All those companies are trying to do is make money off of your cash. Avoid them if possible.
If your employer-provided HSA requires a cash balance before investing, keep in mind that you are allowed to transfer your HSA balance anytime you want. However, these companies typically charge a substantial fee to transfer assets out (e.g. Optum Bank charges $20 per transfer). What this means is that if you do want to transfer to a less expensive, more investment-friendly HSA, you’d want to do so only when your balance is high enough that the $20 doesn’t really impact you all that much. Furthermore, be sure not to transfer the entire account, as that will send the signal to the employer-provided HSA custodian that you want to close your HSA. That’s not good as you’re presumably still trying to make contributions!
3.) When you do have a medical expense, pay for it out of your checking account. Use your Go-Forward budget and include that medical expense as a regular expense. Do not use the HSA to pay for the medical expense. You might be thinking, “What? That’s why I have the HSA! It’s literally in the name the account…the “Health” savings account.” Yep, it is. Still, don’t use it. This is a good idea because you can reimburse yourself out of the HSA at any point in the future tax and penalty free for past medical expenses that you paid for out of pocket while you had the HSA. You are in effect building up a tax and penalty free slush fund/savings account, all while keeping your HSA dollars growing tax free.
4.) Retain proof of payment out of your checking account for those medical expenses. We suggest setting up a digital folder through Box or Dropbox (or something similar) labeled “Unreimbursed Medical.” This is handy should you ever get audited.
5.) Some day in the future, when you have a big expense that you want to pay for with tax-free dollars, you can withdraw from the HSA up to the level of your previously paid-for-out-of-pocket medical expenses.
6.) Upon age 65, the penalty for non-medical use expenses goes away. You can now use the HSA as a regular retirement account. If you use it for non-qualified medical use expenses, the distribution will be taxable but you’ve now avoided the penalty, making it look and feel just like your pre-tax 401(k) or IRA.
7.) You still get to use it in retirement tax-free for qualified medical expenses, including Medicare premiums, LTC expenses, and more.
The HSA is truly the most tax-friendly way to save for retirement in existence.
Using an HSA as a retirement account would most commonly be applicable in NBS:
How to elect the after-tax 401(k)
If you decide that the Roth 401(k) is right for you, then you can either login to NetBenefits.com or go to the NetBenefits app. From there, navigate to the Contributions section. The after-tax section will be labeled Roth.
Roth 401(k) Example
Meet John, a 35 year old Delta employee:
He is making $50,000 a year.
He decides to save 6% on a Roth basis in the 401(k).
John still receives the 6% match and the 3% automatic contribution, making his total contribution 15%.
Even though his own contributions are going into the Roth 401(k), both the 6% match and the automatic 3% contributions go into the pretax 401(k).
The 6% that John saved in the Roth 401(k) is $3,000 and the 9% (6% match + 3% automatic) Delta contribution is $4,500. Because John chose to save his 6% in the Roth 401(k) he pays taxes on the entirety of the $50,000 of his income, including the $3,000 that he put into the Roth 401(k) (ignoring all other deductions, credits, exemptions, etc.). If John had chosen to contribute his 6% on a pre-tax basis, he would pay taxes on $47,000 of income.
Let’s say that after 20 years his contributions from this year have doubled twice [placeholder - let’s create a library item for the rule of 72], making his Roth contributions worth $12,000 ($3,000 X 2 X 2) and his Delta contributions worth $18,000 ($4,500 X 2 X 2).
John withdraws the entirety of these amounts.
The $12,000 of his Roth balance can be taken out completely tax-free.
The $18,000 of his pretax balance is subject to taxes. Let’s hypothetically say that his tax rate is 12% Federal and 5% state. The amount of the $18,000 that he would actually receive would be $14,940 ($18,000 X 0.83).
This outcome doesn’t make Roth better than pretax, per se, but it does show that saving in Roth rewards John’s future self by paying the taxes upfront.
Why would someone choose Roth 401(k)?
This approach is often-times, though not always, used:
By people early in their careers: Because dollars go into the account after paying taxes, the generally accepted truth is that Roth is better when a person’s income is lower now than it would be anticipated to be in the future.
By people who are believe tax rates in general will be higher in the future: Think Congress is going to, or perhaps will have to, increase taxes in the future. Saving in Roth allows you to shelter the gains from future taxation.
By people who want to diversify the way they are saving: Because employer contributions by default go into the pre-tax category, by saving in the Roth 401(k), savers are in effect diversifying the future tax situation. Diversification provides an insurance of sorts against future tax law or income level changes.
FAQs
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There are no income limitations to utilizing the Roth 401(k). This is commonly misunderstood as there are income limitations to the Roth IRA, but keep in mind that the Roth 401(k) and the Roth IRA are different account types.
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You do not have to save in just one of the two options. If you're looking to meet the match you can do any combination of pretax and/or Roth
6% pretax
6% Roth
1% pretax/5% Roth
3% pretax/3% Roth
So on.
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Yes. As long as you are saving 6% in the 401(k), regardless of savings type, you'll receive the match.