# Could a Health Savings Account Be Better than an Employer- Matched 401(k)?

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3 Table 1: After-Tax Future Value (ATFV) Models Investment Model (Examples) 1. Tax Free (Roth IRA, Roth 401(k)) Rate of Taxation Frequency of Taxation Is Initial Contribution Deductible? ATFV Formula None Never No = ATC (1+R) n 2. Tax Savings at Contribution and Tax Deferred Until Pay-Out (401(k), Deductible IRA) 3. Tax Savings at Contribution and Tax Free at Pay-Out* (HSA) 4. Only State Tax Savings at Contribution and Tax Free at Pay-Out** ( 529 Higher Education Savings Account) Ordinary None None Deferred Never Never where: ATC = After-tax contribution R = Annual before-tax rate of return on investment n = Employee s investment horizon, in years t fed = Employee s marginal federal income tax rate at time of contribution t state = Employee s marginal state income tax rate at time of contribution t fica = Employee s marginal FICA tax rates (Social Security and Medicare) at time of contribution t n = Employee s combined marginal federal and state income tax rate at end of investment * Assumes all distributions are to reimburse qualified medical expenses ** Assumes all distributions are for qualified higher education expenses of account s beneficiary Yes Yes Yes = ATC (1+R) n (1 t n ) (1 t fed t state ) = ATC (1+R) n (1 t fed t state t fica ) = ATC (1+R) n (1 t state ) Table 2: After-Tax Future Values n = 20 years; R = ; t fed = 20%; t state = ; t fica = 7.6; ATC = \$2,000 Account Example 1: t 0 * = t n Example 2: t 0 * > t n (t n = 1) 1. Roth (k) 3. HSA** \$5,307 \$5,307 \$7,879 After-Tax Future Value (ATFV) Examples Reviewing Table 1, it is apparent that the HSA formula (3) will result in a higher after-tax future value (ATFV) than any of the other formulas given its substantial tax savings at contribution and no tax cost at distribution. How much wealthier does using an HSA to reimburse QMEs make an individual compared to an unmatched contribution to either a Roth retirement account (1), or a 401(k) (2)? Table 2 provides the answer for one set of facts. The fourth formula, a 529 account, is discussed later. Reviewing Table 2, in the first example column, the Roth and 401(k) \$5,307 \$6,014 \$7,879 * t0 = tfed + tstate = 2 ** Assumes all distributions are to reimburse qualified medical expenses Example 3: t 0 * < t n (t n = 3) \$5,307 \$4,599 \$7,879 have equivalent ATFVs since t 0 = t n. In the second example column, the 401(k) makes the employee wealthier than the Roth, because the tax rate at distribution is lower than the tax rate at contribution. In the third example column, the Roth makes the employee wealthier than the 401(k), because the tax rate at distribution is higher than the tax rate at contribution. In all three examples, the HSA makes the individual much wealthier than contributing to either of the other two retirement accounts. This is true even if the contribution to the HSA is not left in the account for a long time. For example, assume the same facts in Table 2 except that the contribution is withdrawn one year later instead of 20 years later. The ATFV for the HSA is \$3,118. In contrast, if t 0 = t n, the Roth and the 401(k) each have an ATFV of only \$2,100. The HSA s ATFV in both this example and in Table 2 is so much larger than either the Roth or the 401(k) that it raises the question of whether the HSA can increase wealth by more than a retirement account contribution that includes an employer s matching contribution. Next, HSAs will be compared to employer-matched 401(k)s. Adjusting the 401(k) formula (the second formula in Table 1) to incorporate the employer s match on annual 401(k) contributions, the revised formula is: [ATC / (1 t fed t state )] (1 + m)(1 + R) n (1 t n ) The only difference from the formula in Table 1 is multiplying the new term (1 + m), where m is the employer s matching contribution percentage Journal of Financial Planning January 2016

4 CONTRIBUTIONS Table 3: Numerical Examples of Employer-Matched 401(k) versus Health Savings Account Account Example 1 Example 2 Example 3 [1] Employer s 401(k) match rate Investment horizon, in years (n) [2] FICA tax rate (t fica) [3] Federal income tax rate (t fed) [4] State income tax rate (t state) [5] Combined income tax rate during investment (t n) Annual pretax return on 401(k) s assets (R) [6] Employee s contribution (after-tax) Employee contributes to traditional 401(k): [7] Employee s contribution to 401(k) (pretax) [8] Employer s contribution to 401(k) [9] Traditional 401(k) balance at investment horizon end [10] Tax due on liquidation of traditional 401(k) [11] 401(k) after-tax future value Employee contributes to HSA*: [12] Employee s contribution to HSA (pretax) [13] HSA after-tax future value [14] Net advantage of HSA over 401(k) with employer match * Assumes all distributions are to reimburse qualified medical expenses [5] = [3] + [4] [7] = [6] / (100% [5]) [8] = [7] [1] [9] = ([7] + [8]) (1.05) 20 [10] = [9] [5] [12] = [6] / (100% [2] [5]) [13] = [12] (1.05) 20 [14] = [13] [11] % \$2,400 \$3,000 \$750 \$9,950 1,990 \$7,960 \$3,317 \$8,801 \$841 50% % 33% \$4,020 \$6,000 \$3,000 \$23,880 7,880 \$16,000 \$6,773 \$17,971 \$1, % 4 \$6,600 \$12,000 \$9,000 \$55,719 25,074 \$30,645 \$12,536 \$33,261 \$2,616 Employer-Matched 401(k) versus HSA Three examples, summarized in Table 3, illustrate situations where an employee s HSA contribution can increase wealth by more than an employer s 401(k) match of 25, 50, and 75 percent, respectively. The first two examples assume salary does not exceed the Social Security tax base (and are subject to Social Security tax at a 6.2 percent rate, and Medicare tax at a 1.45 percent rate for a total FICA tax rate of 7.65 percent). The third example assumes the entire salary exceeds the Social Security tax base and is only subject to Medicare tax at a 2.35 percent rate (1.45 percent regular rate percent surtax rate). Example 1 in Table 3 assumes an employee is subject to tax rates of 15 percent (federal), 5 percent (state), and 7.65 percent (FICA). Given these assumptions, the combined tax rate is the sum of the three rates (27.65 percent). Assume the employee s salary is \$50,000 and the employer 401(k) match is 25 cents per dollar contributed by the employee on the first 6 percent of salary. Finally, assume the employee contributes just enough to his or her 401(k) (\$3,000) to get the maximum employer match (\$750). To summarize the 401(k), \$3,000 is contributed before-tax (\$2,400 / ( )) by the employee to his or her 401(k); this results in a \$750 employer-matching contribution (25 percent). This all grows to \$9,950 after 20 years (5 percent annual return); income taxes of \$1,990 (20 percent) are paid and \$7,960 remains. (The revised formula in the previous section was used to compute this ATFV.) To summarize the HSA, \$3,317 is contributed before-tax (\$2,400 / ( )). This grows to \$8,801 (5 percent annual return) after 20 years. (The third formula in Table 1 was used to compute this ATFV.) In conclusion for Example 1, contributing \$2,400 after all taxes to an HSA increases wealth by more than contributing \$2,400 after income taxes to a 401(k) with a 25 percent employer match, per dollar contributed by the employee. Example 2 in Table 3 assumes an employee is subject to tax rates of 28 percent (federal), 5 percent (state), and 7.65 percent (FICA), respectively. The combined tax rate is the sum of the three rates (40.65 percent). Assume the employee s salary is \$100,000, and the employer s 401(k) match is 50 cents per dollar contributed by the employee on the first 6 percent of salary. Finally, assume the employee contributes just enough to his or her 401(k) (\$6,000) to get the maximum employer match (\$3,000). To summarize the 401(k), \$6,000 is contributed before-tax (\$4,020 / ( )) by the employee January 2016 Journal of Financial Planning 43

5 Figure 1: Comparison of Employer s 401(k) Matches to Tax Savings from HSA Contribution 100% 7 Note: For points northwest of the HSA line, employees will be wealthier if contributing to employer-matched 401(k)s first. For points southeast of the HSA line, employees will be wealthier if contributing to HSAs first. Immediate Return 50% 2 0% 0% 10% 1 20% 2 30% 3 40% 4 50% Combined Tax Rate in Year of Contribution HSA 2 match 50% match 7 match 100% match to his or her 401(k); this results in a \$3,000 employer-matching contribution (50 percent). This grows to \$23,880 after 20 years. Income taxes of \$7,880 (33 percent) are paid, leaving \$16,000 remaining. To summarize the HSA, \$6,773 is contributed before-tax (\$4,020 / ( )). 3 This grows to \$17,971 after 20 years. In conclusion for Example 2, contributing \$4,020 after taxes to an HSA increases wealth by more than contributing \$4,020 after income taxes to a 401(k) with a 50 percent employer match. Example 3 in Table 3 assumes an employee is subject to tax rates of 40 percent (federal), 5 percent (state), and 2.35 percent (FICA). The combined tax rate is the sum of the three rates (47.35 percent). Also, assume the employee s salary is \$200,000 and the employer 401(k) match is 75 cents per dollar contributed by the employee on the first 6 percent of salary. Finally, assume the employee contributes just enough to his or her 401(k) (\$12,000) to get the maximum employer match (\$9,000). To summarize the 401(k), \$12,000 is contributed before-tax (\$6,600 / (1.45)) by the employee to his or her 401(k); this results in a \$9,000 employer-matching contribution (75 percent). This grows to \$55,719 after 20 years. Income taxes of \$25,074 (45 percent) are paid, leaving \$30,645 remaining. To summarize the HSA, \$12,536 is contributed before-tax (\$6,600 / (1.4735)), and this grows to \$33,261 after 20 years. 4 In conclusion for Example 3, contributing \$6,600 after taxes to an HSA increases wealth by more than contributing \$6,600 after income taxes to a 401(k) plan with a 75 percent employer match. Given the facts in these three examples, the employee would be wealthier contributing to their HSA compared to contributing to their employer-matched 401(k). Break-Even Analysis Figure 1 answers the question of whether employees should contribute first to their HSA or to their employermatched 401(k). The parallel horizontal lines represent employer s 401(k) matching percentages (25 percent, 50 percent, 75 percent, or 100 percent). The vertical axis is the immediate return from either the employer s matching on a 401(k) or the tax savings percentage of an employee investing in an HSA. The horizontal axis is the combined tax rate (federal income, state income, Social Security, and Medicare) and runs from 0 percent to 50 percent. The curved line represents immediate tax savings (return) from investing in an HSA, given the combined tax rate. Because an HSA contribution is made with pretax dollars, immediate return 44 Journal of Financial Planning January 2016

6 CONTRIBUTIONS is higher than the combined tax rate. A simple example illustrates this point. If \$1 is the pretax contribution to the HSA and the employee s combined tax rate is 20 percent, then the employee s after-tax contribution is only 80 cents and the immediate tax savings of 20 cents represents a 25 percent immediate return (0.20 / 0.80). The following summarizes Figure 1 s implications for wealth maximization: If an employee s combined tax rate is greater than 20 percent, and his or her employer s 401(k) match is 25 percent or less, contribute to the HSA before contributing anything to the 401(k). If an employee s combined tax rate is greater than 33 1 /3 percent, and his or her employer s 401(k) match is 50 percent or less, contribute to the HSA before contributing anything to the 401(k). If an employee s combined tax rate is greater than percent, and his or her employer s 401(k) match is 75 percent or less, contribute to the HSA before contributing anything to the 401(k). 5 If all three of the previous statements are false, then the wealth-maximizing order for the employee is to contribute enough to his or her 401(k) to get the maximum employer match before contributing to his or her HSA. In other words, for combinations of employer 401(k) match rate and combined tax rate that lie northwest of the HSA line, employees will be wealthier if contributing to an employer-matched 401(k) first, and for combinations that lie southeast of the HSA line, employees will be wealthier if contributing to HSA first. Other Issues with Maximizing Contributions Now that it has been established what to do first each year, how should the next most wealth-enhancing alternative be financed? At this point a financial planner might ask, Why not tell the clients to contribute to both each year? That may be appropriate advice for clients who do not spend too much of their annual cash inflow. However, many individuals do not contribute enough to their 401(k) to get the maximum employer match now, so even more individuals will be unable to make the maximum contribution allowable to their HSA and make a large enough contribution to their 401(k) to get the maximum employer match. Financial planners should always find out if their clients are eligible to set up an HSA. Fortunately, if the individual contributes to his or her HSA, there is a strategy to finance some or all of their 401(k) contributions that will receive the employer match. As Camp and Hulse (2008, p. 44) point out, Even though it is preferred as a long-term investment, the HSA does present a short-term solution for those individuals with low or no liquid assets who have a current need to pay for medical expenses. The strategy is to take distributions from the HSA to reimburse all QMEs. The reimbursement from the HSA immediately increases after-tax cash flow by the amount of tax savings. The individual can use the tax savings as part of the QME reimbursement, leaving cash that was going to go to pay the QME available to finance other expenses and, thus, contribute more into the 401(k) than he or she would otherwise be able to. If despite following this strategy the employee still cannot contribute enough to his or her 401(k) to get the maximum employer match, refer to and Hulse (2014) for analysis of when a traditional 401(k) contribution increases wealth more than a Roth 401(k) contribution. What to Do Next Assume that financing the maximum contribution to the employee s HSA and enough contribution to his or her 401(k) to get the maximum employer match is not an issue. What is the next most taxefficient strategy for the employee with additional money available? The answer is to pay down high after-tax interest rate debts such as credit card balances. For example, assume an individual has a \$10,000 credit card balance with a 20 percent annual percentage rate. Further, assume the individual has a 25 percent combined tax rate and has an employer 401(k) match of 50 percent. Consistent with Figure 1, this individual should contribute enough to his or her 401(k) to get the maximum employer match of 50 percent first. Because the immediate return on the HSA contribution is 33.3 percent (see the HSA line in Figure 1 that shows a combined tax rate of 25 percent results in a 33.3 percent immediate return), contributing the maximum allowable to the HSA should be accomplished second. Third, any excess available money should go to paying down the credit card balance, since it results in immediate savings of 20 percent annual interest. This rank ordering is based on relative returns: 50 percent match by the employer on the 401(k) contribution first; 33.3 percent tax savings from HSA contribution second; and 20 percent annual interest savings third. Note that there might be some non-tax reasons for using part of the available excess money for some purpose other than January 2016 Journal of Financial Planning 45

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