Choosing the Right Account: Traditional IRA, Roth IRA, or HSA
By Jennifer Bassett, CIP, CISP, CHSP, QKA
While your financial organization might not offer customized advice, it’s essential to understand the basics of retirement savings and tax-advantaged accounts. By sharing general guidance about the pros and cons of popular savings accounts, you can help clients make smarter decisions about their savings options. Let’s explore three of the most common tax-advantaged options—Traditional IRAs, Roth IRAs, and HSAs—and see which might be best for different types of savers.
Traditional IRA: A Classic with Tax Advantages
Traditional IRAs are favorites among those seeking a tax break now. Contributions may be tax-deductible, and some lower-income savers might even qualify for the Saver’s credit. But there’s a catch: when IRA owners start distributing their IRA assets, all those deductible contributions and their accumulated earnings will be subject to income tax. In addition, once IRA owners reach a certain age, they’ll need to start taking required minimum distributions (RMDs), whether they like it or not.
For clients with higher incomes, the ability to deduct contributions and delay taxes until retirement—when they may be in a lower tax bracket—can be especially appealing. Also, if they’re ineligible to contribute to a Roth IRA, a Traditional IRA might be their only option. But keep in mind, deduction eligibility phases out if the IRA owner or her spouse participates in a workplace retirement plan and their income exceeds certain thresholds.
Roth IRA: Tax-Free Growth for Future Gains
Roth IRAs flip the script: Roth IRA contributions are not tax deductible, but qualified distributions are tax- and penalty-free, and there are no RMDs to worry about. Like Traditional IRAs, lower-income individuals may also qualify for the Saver’s credit. The main drawback? Not everyone can contribute—income limits apply.
Clients in lower tax brackets may not benefit as much from deducting Traditional IRA contributions, making Roth IRAs more attractive. Gen Zs and Millennials, for example, may favor Roth IRAs because their earnings—and tax brackets—are likely to rise over time. With decades of growth ahead, tax-free distributions at retirement are a big plus. Roth IRAs also appeal to those seeking more flexibility or a way to diversify nontaxable assets.
HSA: The Triple Tax Advantage and More
Health savings accounts (HSAs) were designed to help individuals with high deductible health plans cover medical costs. But their tax benefits, and the fact that individuals can contribute to an IRA and an HSA at the same time, make HSAs a stealthy contender for retirement savings.
HSA contributions are typically deductible, even for high earners. Employers may allow employees to make salary reductions through a cafeteria plan. HSA contributions made this way are excludable from taxable income just like 401(k) plan deferrals (they are not deducted on the HSA owner’s tax return) and are free from federal income and other employment tax withholding—including Social Security and Medicare.
HSAs are not subject to RMDs, and tax-free distributions are allowed for qualified medical expenses. Also, there’s no rush to withdraw assets; HSA owners can reimburse themselves for qualified medical expenses paid out-of-pocket years after they occur, as long as they keep good records and didn’t pay the expenses with another type of plan or arrangement (e.g., a flexible spending arrangement).
Once HSA owners turn 65, they can use their HSA for anything without paying a 20 percent penalty tax—although nonqualified HSA distributions are still taxable, just like Traditional IRA distributions.
It’s also important to remember that HSA beneficiaries have different payout options than IRA beneficiaries. When an HSA owner names a nonspouse beneficiary and then dies, the account stops being an HSA as of the date of death. The nonspouse beneficiary must include the HSA’s date of death fair market value in his taxable income for the year of death. If the HSA owner’s spouse is the beneficiary, the HSA automatically becomes the surviving spouse’s own HSA at the time of death.
The Takeaway
Ultimately, every client’s situation is unique. Encourage them to consult a qualified tax advisor to find the savings strategy that best fits their goals and circumstances. Traditional IRAs, Roth IRAs, and HSAs all offer valuable tax advantages, but eligibility, tax treatment, and distribution rules vary, making it essential to tailor retirement planning to individual needs. Understanding these differences can help clients maximize their long-term financial benefits.
