When an employer offers both a 401(k) and a high-deductible health plan with a health savings account (HSA), ideally employees will contribute to both accounts. In reality, many will pick one account over the other. Assuming the employer provides a 401(k) match, it may seem as if the best option is to maximize their 401(k) match first, and then fund the HSA with any additional available money.
But let’s think that through. Depending on an employee’s personal tax rate and the amount of the employer 401(k) match, the triple tax advantages – that is, tax-free (pretax or tax-deductible) contributions; tax-free earnings (investment, interest) on accumulated funds; and tax-free distributions for qualified medical expenses – afforded by the HSA could be just as valuable as the employer 401(k) match.
The most common 401(k) matching formula administered by Vanguard is $0.50 cents on the dollar up to 6% of salary (which is also the median 401(k) deferral amount). For a New York employee whose top federal tax rate and top New York State tax rate in 2019 are 22% and 6.33%, respectively (i.e., taxable earnings between $39,476 - $80,650 for unmarried individuals and double for married individuals filing joint returns), a $1,000 employee HSA contribution is worth approximately $1,562 on a tax-adjusted basis ($1,000 / (1-22% Federal Tax – 7.65% OASDI – 6.33% NY State Tax). But notice that a $1,000 employee contribution plus an employer $500 match going into the 401(k) (i.e., $1,500) would be roughly equivalent to the tax-adjusted HSA contribution of $1,000 as described above (i.e., $1,565). The tax advantage for this particular employee generated by his/her $1,000 HSA contribution is slightly better than if the employee received the employer 401(k) match, assuming the HSA withdrawals are used to pay for or reimburse qualified medical expenses; however, changes in the participant’s tax status at the time of 401(k) distributions would impact this comparison.
Employees who fund their 401(k) instead of their HSA secure their employer’s 401(k) matching contribution at the expense of having access to their money when they need it for current medical expenses (ignoring loans and hardship withdrawals, which are discouraged). On the flip side, employees who prefer to fund their HSA to pay for or reimburse current or future medical expenses on a tax-free basis forgo their 401(k) match. What if there was a way to both fund the HSA and still receive the employer’s 401(k) matching contribution?
Here’s a solution to consider: Allow employees to contribute to their HSA and still receive their employer’s matching contribution in the 401(k) plan – with the match being determined by the aggregate amount of the employee’s 401(k) and pre-tax HSA contributions. This mitigates the impact to the retirement benefits that the employer is looking to provide. It also allows employees to use the HSA as a retirement savings vehicle with the security of having the money available for current medical emergencies. If the employee were to get both the employer match into the 401(k) and the triple tax advantages from utilizing the HSA, under a 50% match scenario, the value of the benefit is effectively doubled (50% from the employer + approximately the same amount in tax savings).
As you might expect, there are caveats: Employers would need to be cautious in promoting this approach since they do not know each employee’s tax status (and should steer clear of giving tax advice). In addition, employers will want to ensure they don’t engage in activities that might inadvertently cause their HSA to be subject to ERISA. Also, employers would need to consult with legal counsel on the addition of this contribution arrangement to their 401(k) plans.
But offering this option could help some employees avoid missing out on an important benefit. Because when it comes to picking an account to fund, often times, both are better.
By Bill Mon and Dorian Z .Smith