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401(k) Contributions 'Crowded Out' by HSAs—Does It Matter?

HSAs have unique advantages if funds are held until retirement

A sand hourglass sits next to a stack of coins.

More than half of first-time health savings account (HSA) contributors reduce their 401(k) retirement account payroll-deferred savings rate, meaning HSA contributions "crowd out" 401(k) contributions, according to new research. While this could mean employees with both accounts are likely to have smaller retirement nest eggs, that needn't be the case if at least some of their HSA dollars are used for long-term savings rather than short-term spending.

A Little Here, a Little There

The amount of discretionary funds employees can divert to their benefits is limited, so it's not surprising that in February the nonprofit Employee Benefit Research Institute (EBRI) reported that 56 percent of 401(k) participants reduced their 401(k) contributions in the first year they made HSA contributions (content is behind a member firewall). EBRI examined data from more than 45,000 employees, ages 19 and older, with both a 401(k) and an HSA.

"Not only does the amount of 401(k) contributions decrease as HSA contribution levels increase, the higher the 401(k) contribution, the greater the reduction in 401(k) contribution among those who contributed to their HSA for the first time," said Paul Fronstin, director of EBRI's health research and education program.

At the median, annual 401(k) contributions fell $315 among those contributing more than $4,350 to their HSAs. Among HSA participants contributing $1,000 or less, however, median 401(k) contributions fell only $8.

EBRI also found "crowding out" of employee 401(k) contributions when employers contributed to HSAs, said Jake Spiegel, EBRI research associate. "Those with a higher ratio of employer-to-employee HSA contributions are more likely to reduce their 401(k) contributions."

EBRI's findings suggest that employees are thinking about the funding of their HSAs and 401(k) accounts together, although they may not be fully aware of how both accounts can be used mutually to ensure retirement security.

Income Tax Advantages

One reason employees may want to lower their 401(k) contributions to fund their HSAs is that HSAs have greater tax-saving advantages than either a traditional or Roth 401(k). Here's how the tax treatment for each account works:

  • A traditional 401(k) is funded with pretax dollars, assets invested within the account grow tax free, and withdrawals are taxed as income during retirement.
  • A Roth 401(k) is funded with after-tax dollars, assets invested within the account grow tax free, and withdrawals are tax-free during retirement.
  • An HSA is funded with pretax dollars, assets invested within the account grow tax free, and withdrawals are tax-free during retirement (with a few state tax exceptions).

Payroll Tax Exclusion

There's another tax advantage associated with HSA contributions: Payroll-deferred HSA contributions are not subject to Social Security and Medicare (FICA) or federal unemployment (FUTA) taxes. In contrast, with a traditional 401(k), no income taxes are deducted on employees' payroll-deferred contributions, but FICA and FUTA taxes will be taken from amounts deferred.

Because of an HSA's unique tax advantages, "some retirement experts are even going as far as to advise employees to max out their HSA contributions before maxing out what they're kicking in to their 401(k)," the Chelko Group, a benefits plan management consultancy, blogged last year.

"While it's clear an HSA can only be used for eligible health care expenses before age 65 (without penalty), that's no longer the case once an employee turns 65. After that, they can spend the money on virtually anything―subject to normal taxes―just like with their 401(k)," Chelko's consultants pointed out. "We certainly don't suggest employees discontinue 401(k) contributions, but we do believe plan sponsors can do a much better job of communicating the long-term value of fully leveraging the triple-tax-advantaged HSA for retirement."

HSAs as a Retirement Account

According to a 2020 report by the Defined Contribution Institutional Investment Association, "Using HSA funds during retirement for certain recurring medical expenses—such as Medicare premiums and long-term care insurance—can help [individuals] ensure that their other retirement savings are used for the primary goal of maintaining their standard of living in retirement."

HSAs' role in retirement planning is just starting to be appreciated by employees, said Robert C. Lawton, president of Lawton Retirement Plan Consultants in Milwaukee. He advised, "Begin communicating in your employee education sessions the retirement benefits associated with funding HSAs."

HSA participants should consider contributing up to annual limits if they are able to do so, "not only to take advantage of the tax savings, but also to ensure that they are putting themselves in a position to better afford their future health care," said Shobin Uralil, co-founder and chief operating officer of Lively, an HSA services firm. "Employers can do their part by extending HSA contributions as a benefit to their employees."

Spending or Saving?

The long-term advantage of saving for retirement through an HSA, however, is achieved only if employees are actually using their HSAs to save for retirement.

An EBRI study published in January 2021 found that nearly 40 percent of account holders in EBRI's HSA database withdrew more than they contributed in a given year, "suggesting many account holders are encountering problems with cash flow and need to tap their HSAs to pay for medical expenses," EBRI reported. 

In addition, only 7 percent of HSA participants held assets other than cash in their HSAs, such as mutual fund investments. Investing HSA dollars is a sign that participants are using their HSA as a long-term savings vehicle instead of a short-term spending vehicle, EBRI noted.

Offering the same investment options in the HSA program as in the 401(k) plan can help ease the education barrier around HSA investing, retirement advisors point out.

"It is clear that plan sponsors and administrators can play a critical role in helping account holders take a longer view of HSAs and the role they can play in their financial wellness," Fronstin said.

According to Jack Towarnicky, principal researcher for the American Retirement Association, "While HSAs have been around for more than a decade and a half, employers and participants are only just coming to appreciate their power as an additional way to save for retirement."

He advised, "employers need continued support in explaining the unique benefits of HSAs to employees. Aligning it with their retirement savings programs rather than solely as a separate health benefit can help overcome some of these education barriers."

Related SHRM Articles:

Employees Still Perplexed by HSA Plans During Open EnrollmentSHRM Online, November 2020

For 2021, 401(k) Contribution Limit Unchanged for Employees, Up for Employers, SHRM Online, October 2020

IRS Announces 2021 Limits for HSAs and High-Deductible Health Plans, SHRM Online, May 2020


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