I’m usually diplomatic. But during a recent presentation, I couldn’t help calling a group of people “idiots.”

But when you find out why, I’m sure you’ll agree with me.

[ad#Google Adsense 336×280-IA]You see, these individuals have the ability to participate in a 401(k) plan that featured a company match…

And yet, the majority of them have chosen to sit on the sidelines.

I explained (after calling them idiots) that not only were they passing up free money from their company and not saving for retirement – they were missing the chance to pay less in taxes, too.

Longtime Investment U and Wealthy Retirement readers know all about the tax benefits of 401(k)s.

(If you need a refresher, start with my article “You’re Giving Away $155,000… And You Don’t Even Know It.”)

But today I want to tell you about another program that may be available to you. One that can save you as much as $2,227 in taxes (more if you’re older than 55).

It does this by allowing you to put away money that you’ll have to spend anyway on healthcare. It’s called a health savings account. And it may be even more beneficial than a 401(k). But more on that in a minute.

First, the basics…

An HSA is a savings account used specifically for medical expenses. It can earn interest or even be invested in stocks, ETFs or mutual funds. The money is taken out of your paycheck, pretax. So if you earn $75,000 per year and contribute $5,000 to an HSA, your taxable income is lowered to $70,000.

You don’t have to pay federal taxes or FICA on the contribution either. The money is also exempt from state taxes (with the exception of California, New Jersey and Alabama).

In order to qualify for an HSA, you must have a high-deductible insurance plan. The funds you put in your account must be used for qualified health expenses. Costs like copays, deductibles and lab tests are covered, but so are everyday expenses, such as prescriptions, acupuncture and even condoms.

And if you don’t use the full amount that you contribute in any given year, it rolls over to the following year.

Here’s an example of how well it works. Last year, my son needed braces. We could either pay the orthodontist $5,000 up front or pay in installments – which would cost another $250. Because braces are covered under an HSA, and we had the money in the account, not only did I save $250, but with my tax savings it was like getting the braces for two-thirds the price.

Put another way, if I didn’t have an HSA, the braces would have cost me $5,000. But because I used pretax money from my HSA, my taxable income was lowered by $5,000. That saved me $1,650.

So it was like getting the braces for just $3,350.

Of course, there are limits. The maximum you can contribute to an HSA is $6,750 for a family health plan. So if you’re in the 33% tax bracket, you’ll save $2,227 – more if you pay state income tax. And if you’re 55 or older, you can contribute an additional $1,000.

I max out my HSA because it makes sense to lower my taxes while saving for medical expenses I know I will incur.

But until recently, even I didn’t understand the full power of this plan.

In the January issue of the Journal of Financial Planning, University of Missouri accounting professor Greg Geisler wrote that an HSA could actually be better than an employer-matched 401(k).

Because the 401(k)’s distributions are taxable – unless it’s a Roth – Geisler concluded that the HSA has a higher after-tax future value (ATFV). The only exception is if the employer matches the employee 401(k) contribution 100%. However, most employers match 50%.

Geisler estimates that an HSA contribution can earn an extra $1,971 over 20 years versus a 401(k). (You can read his paper here if you want to get into the math.)

Now, keep in mind, if you want to use the HSA for its intended purpose – paying for medical expenses – you would not likely keep the money growing in the account for 20 years. Even if you did hold on to all the funds in your HSA, you’d be able to spend the money only on medical expenses.

But funds from a 401(k) can be used on anything you want. Which is why I remain a big believer in it as a retirement saving tool.

Still, Geisler’s paper makes a strong case for the HSA. If your employer offers a 401(k) and an HSA, I strongly recommend you use both.

Good investing,

Marc

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Source: Investment U