Traditional 401k/IRA or Roth 401k/IRA? - Perhaps Neither (Week 11)

 

First of all, let me say that the single best thing that you can do to prepare for retirement is put as much money as you can in retirement plan.  It’s amazing how much a $5,000 or more annual deposit can grow to over 30+ years when it is not taxed each year.  And if your company matches a portion of your contribution, you essentially get free money each year as well.

The primary difference between a traditional plan and a Roth plan is that you get a tax deduction for each deposit you make in a traditional plan, thereby reducing your taxes each year you make a contribution.  However, all funds are fully taxed when withdrawn. Roth plans work the opposite way.  While you don’t get a tax deduction for each contribution, any withdrawals you make after 59 ½ are completely tax-free (assuming your plan has been open for at least 5 years).  Therefore, you can think of it as a pretty simple question – do you want to pay more taxes now while you are working in order to pay less taxes in retirement?  Most people chose to reduce their taxes now rather than save taxes later.  According to ChatGPT, data shows that about 4 out of 5 participants choose the traditional 401k/IRA vs. Roth option.

But what if there was the best of both worlds?  One that allowed you to both deduct what you contribute and make tax-free withdrawals.  Amazingly, such a plan exists.  It’s called a Health Savings Account, or HSA for short.  An HSA is a high-deductible health plan that you can use to pay for qualified medical expenses.  To qualify for this special tax treatment, the HSA must meet the following requirements:

• Minimum deductible: $1,650 (self-only) / $3,300 (family)
• Maximum annual out-of-pocket costs: $8,300 (self-only) / $16,600 (family)
  (These numbers adjust annually.)

  No Other Health Coverage

• You cannot have any additional non-HDHP health coverage, except certain allowed coverages (e.g., dental, vision, disability, accident, workers’ comp, or long-term care insurance).

  Not Enrolled in Medicare

• You cannot be enrolled in Medicare Part A, B, or D and still contribute to an HSA

If you choose an HSA, in 2025, you can contribute $4,300 per year if your health plan covers only yourself and $8,550 if you have a family plan.  If you are 55 years old or older, you are allowed to contribute an additional $1,000 each year.  About 40% of all private industry health plans offer an HSA option and about 60% of all participants select this plan when it is available to them. 

Let’s stop for a minute and think of the significant tax advantages of these plans.  If you have a family plan, you can contribute up to $8,300 each year just like you do with a 401k.  Like a traditional 401k plan, you can deduct from your current taxes each dollar you contribute.  And like a Roth plan, as long as you take money out to cover health care expenses, nothing is taxable.  And like both types of 401k plans, money in your account can be invested and grow tax-free.

 

Turning Your HSA into a Retirement Plan on Steroids

The vast majority of the people that have an HSA use the funds to pay ongoing medical expenses.  Given that by definition these are high-deductible plans, using the money in the HSA to cover regular medical expenses makes perfect sense.  After all, this is what the money is for.  And using the money for this purpose does not eliminate the tax benefits listed in the chart above.  But what if you pay these expenses out of pocket and invest the HSA balance for future use?  All HSAs come with a group of investment accounts similar to your 401k.  Typically, once you have $1,000 in your account, any additional funds can be invested just like your 401k plan.  Then let the balance compound without taxes for a bunch of years and you will have a pot of money you can access tax free in retirement.

But what if I stay healthy in retirement?  How do I access my HSA tax-free?

First, that is not likely to happen.  Even Medicare comes with out-of-pocket costs that you will need to pay.  In addition, you can use your HSA to cover both Medicare premiums and long-term care premiums.  Wouldn’t it be nice to cover those expenses with tax-free money?

And now for the real trick to generate tax free income you can spend on anything

HSAs have no limit on how long you take to reimburse yourself for out-of-pocket health care expenses.  Remember all of those medical expenses you paid out of pocket over the years in order to build your HSA investment account balance?  Simply, keep the receipts.  If you need extra money in retirement just pull out some of those receipts and instruct your HSA administrator to send you a check to reimburse you for those expenses.  It doesn’t matter if it’s 3 months, 5 years or even 40 years later.  How you decide to spend that reimbursement money is completely up to you.

Yes, this is hard to do

First, I know that when you have funds set aside specifically to cover medical expenses, it’s tempting to use those funds each and every year, especially since you have to select a high-deductible plan just to be eligible.  It’s even tougher if money is tight.  Only about 1 in 10 HSA participants have any of their HSA money invested at all.  While there is no reliable data, it’s likely that less than 2% have accumulated an investment balance of at least $10,000.  But I would encourage you to give it a try.  Deposit as much as you can each year.  At the very least, deposit the money you save in health care premiums by selecting the high-deductible plan rather than the traditional plan.  Do your best not to spend the money.  Make sure you set up an investment account within the HSA and select stock funds with a good track record.  Your future self will thank you if you can pull this off.