Why your next dollar shouldn't go to your 401(k)

Characteristics of a 401(k) millionaire

When it comes to saving for retirement, there may be a better place for your next dollar than your 401(k).

Most people don't think of their health savings account -- HSA, for short-- as a way to save for retirement, but it can be.

The big draw: it's tax free as long as you use the money for medical expenses. Contributions aren't taxed when they go in, and you don't pay taxes when you take money out either. Funds in a traditional 401(k), on the other hand, are taxed as income when you withdraw.

Anyone with a high-deductible health plan can get an HSA. It's designed to help you save for out-of-pocket medical costs and a growing number of people have one. About 14 million Americans do, a 25% jump over the year before, according to a survey of 100 HSA providers by investment firm Devenir.

Money Essentials: All about retirement planning

The money in your HSA can be invested into stocks and bonds, just like your 401(k). Fidelity expert Doug Fisher suggests keeping enough of the money in cash to cover your out-of-pocket medical expenses for the next year, and investing the rest. Be sure to check with your provider to see if they require a minimum before investing.

As with a 401(k), many companies offer contributions to a worker's HSA plan. About 84% of employers that offer HSAs make tax-free contributions, according to PwC. But they typically come as a lump sum rather than a matching contribution. If you do have both accounts, contribute enough to your 401(k) to get the full match first. Then turn to your HSA.

Another benefit: You can withdraw from your HSA at any time, while you'll be penalized for taking money out of your 401(k) before age 59 ½.

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There are a few caveats, though. First, an HSA can only be used for medical-related costs, otherwise you'll get hit with a 20% penalty and owe regular income taxes. But health care is a major expense in retirement. Medicare doesn't cover everything and Fidelity estimates that a couple spends about $220,000 for health care in retirement.

"As we get older, we always need money for health care," Fisher said.

For those older than 65, HSA funds can be used to pay for Medicare and long-term care premiums, too. You'll avoid the 20% penalty if withdrawing for non-medical expenses after 65, but you'll still have to pay income tax.

Second, contribution limits are much lower than a 401(k), and include any money you get from your employer. You can contribute up to $3,350 a year, or $6,650 for a family, including the company contribution, compared to $18,000 to your 401(k). Like most retirement accounts, you can contribute more as you get closer to retirement age.

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Plus, having an HSA means you must also have a high-deductible health plan. That might be all your employer offers, in which case, it's a no-brainer. But if you do have a choice, do the math to see if it's worth passing up a plan with a lower deductible. It could be, depending on how much medical care you'll need and how much your employer contributes to your HSA.

A healthy person might be paying for more insurance than they need, Fisher said. With a more expensive plan, you're paying premiums right to the insurance company and if you don't use it, you lose it. But with a high-deductible plan, you can stash your money in an HSA instead -- which you get to invest and save for future health care costs.

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