Are your clients using the wrong account to save for retirement?

Traditional wisdom suggests that clients should always stash enough money in a 401(k) to capture an employer matching contribution year as the first step toward achieving a secure retirement.
But a provocative article in the Journal of Financial Planning by Greg Geisler, associate professor of accounting at the University of Missouri-St. Louis, challenges that assumption.
Mr. Geisler suggests that in many cases, the tax savings on an employee’s contribution to a health savings account could trump the wealth-building potential of a similar contribution to a 401(k) — even one that includes an employer’s matching contribution.
The reason: HSAs offer a triple tax break. Contributions are made with pre-tax dollars; assets grow tax-free; and distributions are tax-free if used for qualified medical expenses. In comparison, traditional retirement accounts are tax-deductible up front but taxable upon distribution. And contributions to Roth IRAs and Roth 401(k)s are made with after-tax dollars but are tax-free upon withdrawal after age 59 ½.
HSAs, which require that an individual be enrolled in a high-deductible health plan, are quickly becoming more common. At the end of 2014, assets in all HSAs, both those provided by employers and those that are not, totaled $24.2 billion in almost 13 million accounts, Mr. Geisler wrote.
CONTRIBUTION LIMITS
For 2016, the maximum total contribution to an HSA allowed from the employer and employee combined is $3,350 for an employee with self-only health insurance coverage and $6,750 for an employee with family coverage. These amounts are indexed for inflation. For an individual age 55 or over, an additional $1,000 contribution is allowed. Any employer contributions are tax free to the employee.
An employee’s contributions to an HSA are not subject to federal income tax, state income tax (except in Alabama, California and New Jersey) or FICA taxes if made through an employer’s HSA plan.
Distributions from an HSA are tax-free if used to either directly pay or get reimbursement for the qualified medical expenses of the taxpayer, his or her spouse and any dependents claimed on the taxpayer’s federal income tax return.
Unlike flexible savings accounts, HSAs do not have a use-it-or-lose-it rule and are portable. That means those who can afford to pay their medical expenses out of pocket can allow their HSA assets to continue to grow and serve as a tax-advantaged savings account for health care expenses in retirement.
And those future expenses could be substantial. Fidelity Benefits Consulting estimates that a 65-year-old couple retiring in 2015 with Medicare as their primary insurance will need $245,000 in today’s dollars for health care costs during retirement, excluding nursing home care.
Once an individual signs up for Medicare Part A, that individual can no longer contribute to an HSA, but he can continue to take distributions tax-free from an HSA.
FUNDING HIERARCHY
Because an HSA contribution is made with pre-tax dollars, the immediate return is higher than the combined tax rate, Mr. Geisler explained, using this simple example. If the pre-tax contribution to the HSA is $1, and the employee’s combined tax rate (federal income tax, state income tax, Social Security and Medicare) is 20%, then the employee’s after-tax contribution is only 80 cents and the immediate tax savings of 20 cents represents a 25% immediate return (0.20/0.80).
“The higher an employee’s combined tax rate, the larger the employer’s 401(k) match must be to beat contributing to an HSA first,” he wrote.
Mr. Geisler recommended the following hierarchy for clients with multiple financial planning goals.
First, contribute the maximum amount to an HSA and then contribute enough to a 401(k) to get the maximum employer match. Next, if money is still available, focus on paying down high-interest debt. Then contribute to a 529 plan if paying for college is a goal and the contribution produces a state income tax savings. Finally, contribute the maximum allowed for the year to unmatched retirement accounts.
“HSAs need to be incorporated into financial planners’ recommendation to individuals,” Mr. Geisler stressed.
Separately, Michael Kitces, director of research for Pinnacle Advisory Group and publisher of the financial planning industry blog Nerd’s Eye View, noted that the triple tax break of an HSA underscores the value of this type of account as an alternative way to save for retirement.
“The HSA is really the best savings account for retirement for those who can afford to contribute to retirement accounts and an HSA and have the cash flow or reserves to pay medical expenses out of pocket,” Mr. Kitces wrote. That presumes, of course, that the HSA dollars will be invested for growth in the long run, not held in a cash or low-return holding account, he added.
Mary Beth Franklin is a contributing editor to InvestmentNews and a certified financial planner.