Why Experts Recommend HSA as a Powerful Alternative to Roth IRA

When it comes to allocating money among various account types, savers often find themselves faced with a daunting challenge. With 401(k) plans, individual retirement accounts, 529 plans, high-yield savings accounts, taxable brokerage accounts, flexible spending accounts, health savings accounts, and more, the options can feel overwhelming. Each individual has unique circumstances, which means the optimal financial strategy will differ from person to person.

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However, financial advisors suggest that for many people, there is a clear path to follow. Once you have saved enough to receive your company’s full 401(k) match, the next step is to save your additional funds in a health savings account (HSA) if it is available to you.

“Imagine a Roth IRA, but extra strength,” said Sabino Vargas, a certified financial planner and senior financial advisor at Vanguard Group.

“People don’t realize how amazing HSAs can be,” said Carolyn McClanahan, a certified financial planner based in Jacksonville, Florida, and a member of CNBC’s Advisor Council.

This is largely due to the significant tax advantages that HSAs offer compared to other types of accounts. HSAs provide a “triple tax advantage,” according to Vargas. Contributions are tax-free, investment growth is tax-deferred, and withdrawals are tax-free if used for eligible medical expenses.

This means that savers can potentially avoid paying taxes on their HSA funds, unlike with retirement accounts such as pre-tax or Roth IRAs.

According to a recent report from Vanguard, a $1 investment in a pre-tax or Roth IRA would yield $2.98 after 25 years. However, the same $1 invested in an HSA would yield $4.29 over the same time period. These calculations are based on various assumptions about investment returns and tax rates.

Due to the inevitability of healthcare expenses in old age, HSAs can serve as a valuable tool for retirement preparation, functioning as an “off-label account,” as Vargas describes it.

HSAs also offer additional advantages. Savers can choose to invest a portion or all of their balance, and the accounts are portable, meaning the funds can be taken with them if they change employers.

Financial advisors recommend that savers keep enough cash in their HSA to cover their insurance deductible and invest the rest, similar to how retirement funds are managed. They also suggest paying for current health costs out of pocket and allowing HSA investments to grow. Receipts can be saved and redeemed for reimbursement in the future.

The IRS defines qualified medical expenses as those that are generally eligible for the medical and dental expenses tax deduction. A comprehensive list of these expenses can be found in IRS Publication 502. Advisors note that the list is relatively extensive.

If HSA funds are used for non-qualifying health costs, one prong of their three-pronged tax benefits is lost, and savers would owe income tax on the withdrawal. However, they would still be taxed similarly to a 401(k) or IRA in this scenario. (Note: HSA users younger than age 65 would also owe a 20% tax penalty in addition to income tax.)

It’s important to note that not everyone has access to an HSA. These accounts are only available to individuals enrolled in high-deductible health plans, which may not be offered by employers. Additionally, a high-deductible plan may not be financially advantageous for everyone compared to a traditional co-pay health plan.

Most people face budget constraints, leaving little (if any) money remaining after covering essential expenses. For those with access to a 401(k) plan, financial advisors recommend prioritizing savings to receive the full employer match.

“We never want to miss out on free money,” says Vargas.

A 401(k) plan can also double as an emergency fund, as it allows for hardship withdrawals, which most employers permit.

The next priority is typically to max out contributions to an HSA, according to McClanahan, the founder of Life Planning Partners. In 2023, individuals can contribute up to $3,850, while families can contribute up to $7,750.

There are certain circumstances that may alter this approach to HSAs. For example, if a saver has credit card debt, it may be more advantageous to prioritize paying it off rather than funding an HSA, according to McClanahan.

Similarly, individuals without an emergency fund should focus on saving at least one month’s worth of living expenses before maxing out their HSA contributions. Once that is achieved, attention can shift to expanding the emergency savings to cover three to six months of expenses.

If there is still money available after following these steps, additional saving strategies may include contributing to IRAs, 529 plans, additional 401(k) savings, and taxable accounts, as recommended by advisors.