“When a client comes to you for help maximizing their retirement savings and minimizing taxes, what is your first move? Typical responses include maxing out any retirement accounts, such as 401(k)s and IRAs, and for some taxpayers, this will take them a long way toward their goals. For others, retirement accounts can actually be ticking time bombs, especially for taxpayers who end up in a higher tax bracket in their retirement years. Restrictions like mandatory distribution rules and age limits mean that taxpayers may be forced to take out more money than they need at times when taxes are at their highest.
As a proactive tax planner, you know that there is no one magic solution that works for every taxpayer. Part of the value you add is to introduce alternative tax strategies to clients who can benefit from them most. Today we’ll cover two “triple tax advantage strategies”: health savings accounts (HSAs) and 401(h) plans.
The Triple Tax Advantage
Using HSAs for retirement savings come with three major tax benefits:
1. Contributions to an HSA reduce the taxpayer’s taxable income
2. The funds are not taxed while they are in the account, even if they earn interest or investment returns
3. The funds are not taxed when they are withdrawn as long as they are used for qualified medical expenses
You will also want to ask if your client’s employer makes HSA contributions. Some will offer this as a special employee benefit, similar to a 401(k) match. If your client also has a flexible spending account (FSA), you may also want to clarify how the two are different, since some taxpayers get this confused with the HSA. HSAs do not have a “use it or lose it” rule—any unused funds automatically carry forward each year. HSAs are also owned by the employee and not the employer, so even if your client leaves their employer, they can transfer their HSA funds to a new account.
HSA Limitations
Do HSAs come with any significant restrictions? Yes, but they may not create much of an obstacle for your clients. The first one is that HSA holders cannot withdraw their funds until age 65—or they will face a 20% penalty. Here’s the good news: We don’t want our clients withdrawing funds early, anyway. The best way to maximize HSA savings is to pay any current medical bills out-of-pocket, invest those HSA funds, and let them grow tax-free. Not only will this result in more tax-advantaged retirement savings, the taxpayer can still enjoy medical expense reimbursements later on. That’s because HSAs have no time limit on reimbursements. All the taxpayer needs to do is keep sufficient documentation of any medical expenses. Then during retirement, they can begin to withdraw funds to cover any past health care bills and keep that money in pocket. Just note that to qualify for reimbursement, those expenses cannot be paid for by another health care plan or be listed as itemized tax deductions.
The second restriction is that HSA funds can only be used for medical expenses. Otherwise, the taxpayer forfeits that triple tax advantage and will have to pay ordinary income tax on any withdrawals used for non-medical purposes. The good news is that if the account holder is aged 65 or older they will not face a penalty for using funds for other expenses.
However, this does not necessarily mean the taxpayer should avoid maxing out their HSA contributions. In 2024, Fidelity released a report titled “Retiree Health Care Cost Estimates,” which estimated that a couple retiring at age 65 spends an average of $330,000 on medical expenses over the course of their retirement. More likely than not, the taxpayer will be glad to have invested so much into their HSA and received those triple tax benefits to boot.
401(h) Plans vs. HSAs
A 401(h) plan is similar to an HSA in many ways, although there are different restrictions on who can open one. A 401(h) must be set up by a business or organization. They function as health expense accounts attached to a cash balance plan and are most often used by highly-compensated employees or business owners. The employer also determines whether the account can receive both employer and employee contributions. If the employee can make contributions, they are considered tax-deductible. When the employer makes contributions, they can be written off as a business expense.
401(h) plans come with the same triple tax advantage as HSAs: lowering taxable income, generating tax-free earnings in the account, and allowing for tax-free withdrawals for qualified medical expenses. Account holders can use funds to pay for dependents’ medical expenses as well. One other benefit is that the age limit is lower: Once the account holder reaches age 59 ½ they can take tax-free and penalty-free withdrawals.
Summary
HSAs and 401(h) plans are unmatched in their triple tax advantages. Though other alternative retirement strategies like captive insurance or IC-DISCs come with some of the same benefits, they don’t offer tax-free growth on investment earnings. Don’t let taxpayers get caught up on the fact that funds can only be used for medical expenses. The flexibility, control over timing, and tax savings that come with these accounts can make them well-worth the investment.
To learn more about alternative retirement strategies and their unique tax benefits, sign up to become a Certified Tax Planner today.
