HSA vs 401k – Which Account to Fund First?

HSA vs 401k

Do you have both an Health Savings Account (HSA) and a 401(k) through your employer? HSAs are generally thought of as a vehicle for healthcare savings, because it’s right in the name. Most most people understand that a 401k is used for retirement. A lot of people wonder though, which account should they fund first, the HSA vs 401k. Let’s compare the two benefit accounts.

HSA vs 401k – What is the difference?

What is an HSA?

Established in 2005, a Health Savings Account is a tax-advantaged benefit account that may be sponsored by an employer or financial institution. When a person enrolls in a qualified High Deductible Health Plan (HDHP), they are eligible to open an HSA. The account may be used for qualified healthcare expenses and then later used after age 65 for retirement. Once it’s opened, you can keep the account for life. Even if you change your insurance plan or leave your employer, you keep the HSA and can continue using it.

With an HSA, you get a triple-tax advantage:

  1. Tax-free contributions
  2. Tax-free earnings (interest and investment)
  3. Tax-free withdrawals (distributions) for qualified healthcare expenses

Every year you are enrolled in an HDHP, you can make HSA contributions. 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 perk of an HSA is that beginning the year you turn 55, you can contribute an additional $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 if were ordinary income, without any tax penalty. It is treated essentially the same as money withdrawn from a retirement account.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. Depending on the company’s benefit plan, some employers contribute to their employees’ HSAs.

What is a 401k?

Since its creation in 1978, a 401k plan has become the most popular employer-sponsored retirement plan in America. Funded through a payroll deduction, a 401k is a tax-advantaged account, allowing you to contribute money before taxes are taken out of your paycheck. The account is typically invested in mutual funds and it grows tax-free over time. After age 59.5, you can withdraw the money without penalty, however, all distributions (withdrawals) are taxed as ordinary income.

Two tax advantages of a 401k are:

  1. Tax-free contributions
  2. Tax-free growth

Learn more about the current annual limit on 401k contributions.

Which account should I fund first?

For people who have both accounts, one of the biggest questions is which account to fund first, HSA or 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 may be used for both immediate and long-term healthcare needs and funds are not taxed when used for qualified expenses. An HSA can serve as a supplementary retirement account as well. This is because distributions after age 65 are not penalized when used for non-eligible expenses.

Also consider that healthcare costs continue to rise. A recent study estimates that a 65-year old couple who retired in 2019 can expect to spend $285,000 in healthcare and medical expenses throughout retirement.

With a 401k, all withdrawals are taxed, no matter what the money is used for. Plus, with a 401k, you risk a penalty for any withdrawal before the age 59.5.

HSA vs 401k Comparison

Tax-free ContributionsYesYes
Tax-free EarningsYesYes
Tax-free WithdrawalsYes, for qualified healthcare expensesNo
Penalty for WithdrawalsOnly for non-qualified expenses before age 65For 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 both the short and long term by prioritizing the HSA.

For 40 years, DataPath has been a pivotal force in the employee benefits, financial services, and insurance industries. The company’s flagship DataPath Summit platform offers an integrated solution for managing CDH, HSA, Well-Being, COBRA, and Billing. Through its partnership with Accelergent Growth Solutions, DataPath also offers expert BPO services, automation, outsourced customer service, and award-winning marketing services.

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