Do you have both a Health Savings Account (HSA) and a 401(k) through your employer? HSAs are generally thought of as a vehicle for healthcare savings – after all, that’s right in the name! – and most people understand that a 401k is used for retirement. Many wonder, though, which account they should fund first, the HSA or 401k. Let’s compare the two.
HSA vs 401k – What is the difference?
What is an HSA?
Established by legislation in 2005, a Health Savings Account is a tax-advantaged benefit account that an employer or financial institution may sponsor. When a person enrolls in a qualified High Deductible Health Plan (HDHP), they can open an HSA. The account can be used for qualified healthcare expenses at any time and, after age 65, also for non-medical retirement expenses. Once opened, you own the HSA account for life (or until you close it). Even if you change your insurance plan or leave your employer, you keep the HSA and can continue using it.
HSAs provide their account owners with what’s known as the “triple tax advantage”:
- Tax-free contributions
- Tax-free earnings and growth (through interest and investment gains)
- Tax-free withdrawals (distributions) for qualified healthcare expenses
As long as you are actively enrolled in an HDHP, you can make HSA contributions. Depending on the company’s benefit plan, some employers may contribute to employee HSAs. The IRS does publish annual contribution limits, so you’ll need to stay educated on the changing limits. You can also invest part of the balance to help the account grow.
An additional HSA perk is that beginning in the year you turn 55, you can contribute up to an extra $1,000 over the annual limit each year. It’s considered a “catch-up” contribution. Plus, after age 65, money used for non-qualified expenses is taxed as ordinary income without any tax penalty, essentially the same as if the funds were withdrawn from a retirement account. If you use the HSA for non-qualified expenses before age 65, there is a penalty plus the tax.
Learn more about current limits here.
What is a 401k?
Since their creation in 1978, 401k plans have become America’s most popular type of employer-sponsored retirement plan. Funded through payroll deduction, the 401k is a tax-advantaged account that allows you to contribute funds from your paycheck, thus lowering your taxable income before taxes are calculated. The 401k account is typically invested in mutual funds and grows tax-free. Starting at age 59.5, you can withdraw money from the account without penalty. However, all distributions (withdrawals) are taxed as ordinary income regardless of your age, and if you are younger than 59.5, you will also face an early withdrawal penalty.
Two tax advantages of a 401k are:
- Tax-free contributions
- Tax-free growth
Learn more about the current annual limit on 401k contributions.
Which account should I fund first?
One of the biggest questions for people with both accounts is which to fund first, the HSA or the 401k. Both accounts serve as vehicles for financial wellness. However, the HSA has a distinct advantage over the 401k.
Even though an HSA has a lower annual contribution limit, it offers more flexibility. The account can be used for immediate and long-term healthcare needs, and withdrawn funds are not taxed when used for qualified healthcare expenses, regardless of age. With a 401k, all withdrawals are taxed, no matter what the money is used for.
Because funds can be withdrawn for any reason without penalty once you reach age 65, an HSA can also serve as a supplementary retirement account. Withdrawals after age 65 for non-medical expenses are taxed like ordinary income, just like withdrawals from a 401k.
HSA vs 401k Comparison
| HSA | 401k | |
| Tax-free Contributions | Yes | Yes |
| Tax-free Earnings | Yes | Yes |
| Tax-free Withdrawals | Yes, for qualified healthcare expenses | No |
| Penalty for Withdrawals | Only for non-qualified expenses before age 65 | For all withdrawals before age 59.5 |
Next time you start debating on which account to fund first – HSA vs 401k – consider the advantages and disadvantages of both before deciding. You may find that you are better off in the short and long term by prioritizing the HSA.
DataPath is a leading innovator in the employee benefits, financial services, and insurance sectors. Our flagship benefits platform provides a comprehensive solution for managing CDH, HSA, Well-Being, COBRA, and Billing. In addition, we offer expert BPO services, contact center solutions, and award-winning marketing services.