HSA 'Chicken' or 401(k) 'Nest Egg' - Which Comes First?

On January 4, 2018, Morningstar’s W. Scott Simon, posted an article titled “When an HSA-First Strategy Makes Sense:  Why the standard advice about the sequence of contributions to a 401(k) plan and health savings account is flawed--and must-know advantages of HSAs.” (See: http://news.morningstar.com/articlenet/article.aspx?id=842764)   

Scott asserts, in part, “… employees should first max out contributions to their HSAs no matter their tax bracket, and once that's done, contribute to their 401(k) plans. HSA tax savings even beat the employer's match.”  He includes an example to demonstrate that contributing the same dollar amount from take home pay to an HSA each year for 30 years might result in an account balance that is 42% higher than the same contribution to a 401k.  He offers many other comments that suggest workers should contribute first to the HSA.  

So, while I regard myself as a champion of Health Savings Accounts, I respectfully disagree with his contribution priorities in choosing between the HSA and the 401k.    

The Right Answer – Max Out Savings - If You Can Afford It
Obviously, both types of accounts offer very valuable tax preferences.  So, the “right” answer may be to maximize contributions to both.  For a single worker with single HSA-qualifying coverage who is under age 50, that would be $18,500 to a 401(k) and $3,450 to the HSA in 2018.   And, if you can afford it, and your plan permits it, you may want to consider whether the 401(k) contribution should be made, in part or in total, as a Roth 401(k) contribution.  

Because most workers do not change employers each year and because most workers do not earn wages that exceed the Social Security wage base, those who want to max out tax preferred savings should consider making a contribution election before the year starts to take an equal amount each payday that will total up to the annual, tax code maximum.  For a worker under age 50 who is paid semi-monthly, that would be about $771 to the 401k and $144 to the HSA each payday, a total of $905 where, if contributed pre-tax, it may reduce each net paycheck by about $630 (assuming 25% federal, 5% state, 7% FICA & FICA-Med).  For many, accumulating the most in both programs as soon as possible may be the best option because:

• It is invested for a longer period of time, and
• Potential events may limit a worker’s ability to access these tax preferred programs in the future:
  -A period of unemployment, 
  -Voluntary or involuntary turnover (the next employer may or may not offer a 401k or a HSA-qualifying health plan),
  -Potential changes in the tax code that would limit future tax preferred contributions, etc.  

Most people can’t afford to save the max – reducing their take home pay by about $630.  Those workers should consider contributing enough so that the annual addition to the 401(k) plan is 15% of pay or more, and so that the contribution to the HSA is maximized.  For someone earning the median wage in America, ($30,533 according to the Social Security Administration, 2016), where there is no employer contribution to the 401(k), that would be tax preferred contributions to both plans of about $8,000 ($4,580 + $3,450).  

Finally, if that is too much, consider contributing enough to get the full employer contribution to your 401(k) and max out your contribution to the HSA.  Again, for someone earning the median wage in America, where the employer offers a traditional match of 50% of the first 6% of pay contributed, that would mean tax preferred contributions to both plans of about $5,300 ($1,832 + $3,450).

The “Savvy” Answer for Those Just Getting By Financially
The important question to ask may be how to prioritize for those who have limited ability to save.  Say, we have a single worker under the age of 50 who is earning that median wage in America, $30,533..  She/he can only spare $80 (pre-tax, about $50 after-tax) per semi-monthly paycheck in 2018.  The questions might be stated as: 

• Which plan should receive the first contribution?  Or, 
• How should contributions be allocated between the two programs? 

The answer depends, in part, on a number of factors, including but not limited to:  geographic location, the match (if any) in the 401k plan, whether the 401k plan offers a robust loan feature, whether there is an employer contribution to the HSA and if so, whether it is in the form of a match or if it meets the comparability rules.  Because 401(k) and HSA designs are diverse, other factors may also affect this decision.  

Here is the savvy answer, assuming the worker has no other available, accumulated funds:

1. Contribute the minimum to open the HSA the first day the worker has HSA-qualifying health coverage.  
2. If the HSA has no employer contribution or if the employer contribution is based on comparability rules, the worker may want to reduce HSA contributions to $0 after that initial, minimum contribution.   
3. If the 401k has a matching contribution (say 50% of the first 6% of pay contributed), the worker may want to contribute at least 6% of pay ($76) each semi-monthly payday.   
4. If the 401k has a loan provision, the worker may want to borrow and use those monies to offset the reduction in take home pay when she starts regular HSA contributions later in the year.  
5. If the above doesn’t result in a maximum HSA contribution, a worker might want to consider accessing monies from other sources (savings accounts, relatives, etc.) to max out their HSA contributions.    

Here’s the rationale: 

1. In all but a few states, a contribution is required to start the clock running – so any qualifying medical expenses you incur once the HSA is opened will generally qualify for tax free reimbursement – even if most of your HSA contributions are not made until a much later date.      
2. A minimum contribution may qualify for the full employer contribution under comparability rules.  
3. A $76 (6%) pre-tax contribution lowers current taxes; qualifies you for a $38 (3%) employer match.
4. When you contributed $76 to the 401k, your net pay declined an estimated $55 (you avoided approximately $21 in federal and state income withholding taxes).  When you borrow the same $76 from the 401k plan*, it will provide a cushion sufficient to offset an HSA contribution of approximately $121.  Loans are not permitted from HSAs.  
5. Because an HSA contribution reduces your current year tax bill by $.37 for every dollar contributed, and because investment earnings on the HSAs monies may ultimately be paid tax free, this is a superior option for any other accumulated savings, or even a credit card cash advance (especially if employer contributions to the HSA are in the form of a matching contribution).  The incentive to save in the HSA is less where workers are subject to lower marginal tax rates.    

* Plan sponsors should consider facilitating savings by middle class Americans who do not believe they have sufficient funds to contribute to both plans, plan sponsors may even want to maximize access to liquidity from a 401k plan by offering 21st Century electronic functionality and a line-of-credit process.