Check your latest investment statements and you get an instant snapshot of how much your accounts are worth. But that can be a deceptive picture. For many accounts, you will have to pay tax once you decide to spend that money. In terms of wealth building, what counts is not today’s statement balances, but what is left for you to spend after settling your tax bills.
For instance, if you’re diligently saving for retirement in a traditional 401(k) or traditional IRA, every dollar you eventually withdraw will be taxed as income. That effectively reduces their wealth-building mojo by whatever your income tax bracket will be in retirement. If you live in a state that taxes retirement income, your net after-tax wealth will get another haircut before it lands in your checking account.
If you’re saving in a Roth 401(k) or Roth IRA your withdrawals will be tax-free. But remember that you’ve already paid tax: Your contributions were made with income that was already taxed.
With a regular taxable account, you likely will owe capital gains tax on any profits when you sell.
The upshot is that when you are using 401(k)s, IRAs and regular accounts to build wealth there’s a tax bill somewhere in the process.
HSAs: The No-Tax Alternative
A health savings account (HSA) does 401(k)s, IRAs, and regular investment accounts one better on the tax front. The wealth you build in an HSA can be 100% tax-free. Forever.
An HSA is an investment account that is only allowed if you are enrolled in a high deductible health insurance plan (HDHP). You can use money in your HSA to pay your current medical out-of-pocket costs, or you can treat the HSA as a retirement account and keep the money growing for years.
Treating an HSA as a retirement account is one of the most valuable ways to build wealth.
There will be no tax on HSA withdrawals if the money is used for a qualified medical expense. That makes an HSA a lot like a Roth 401(k) or Roth IRA: no tax bill when you spend the money.
HSAs also give you an upfront tax break just like a traditional 401(k) or IRA: the money you contribute nets you a tax deduction. Moreover, just like all 401(k)s and IRAs, you never have a tax bill while your money remains invested inside the account.
The upshot is that an HSA basically gives you your tax cake and lets you eat it too. The triple-tax break on HSAs is even better than traditional retirement accounts.
In 2020, if your health insurance covers your family, you can contribute $7,100 to an HSA. Individuals can contribute $3,550. (If the account holder is at least 55 the limit is $8,000 because of the catch-up contribution rule) If you save $7,000 a year for 10 years and earn an annualized 7%, you would have more than $100,000 in your stealth retirement account. Even if you stopped making new contributions but just let the balance keep compounding for another 15 years you will have more than $280,000 waiting for you in retirement. That money will be tax-free if you use it to pay medical bills (including old medical bills you covered out of pocket years ago) and long-term care.
Disclaimer: the content presented in this article are for informational purposes only, and is not, and must not be considered tax, investment, legal, accounting or financial planning advice, nor a recommendation as to a specific course of action. Investors should consult all available information, including fund prospectuses, and consult with appropriate tax, investment, accounting, legal, and accounting professionals, as appropriate, before making any investment or utilizing any financial planning strategy.