Individual Retirement Accounts (IRAs) and Health Savings Accounts (HSAs) are two types of tax-advantaged accounts that help you save for the future while minimizing tax liabilities. Here’s how you can make the most of each and when to use those different types of savings accounts.
WHAT IS AN IRA?
An Individual Retirement Account, or IRA, is a savings account with tax benefits to set aside money for retirement. It’s an important complement to a 401(k), which may not accumulate enough savings to get you through retirement.
There are two main types of IRAs, each with their own tax advantages:
Traditional IRA: A traditional IRA allows you to make contributions that are tax-deductible, depending on your income. The dividends you earn grow tax-deferred until you withdraw them in retirement. Because you pay income taxes at the time of withdrawal, and many people are in a lower tax bracket after they retire, the tax-deferral could allow the funds to be taxed at a lower rate.
Roth IRA: With a Roth IRA, contributions happen after taxes are paid. Your funds grow tax-free and distributions aren’t taxed at all when you take them in retirement, provided certain conditions are met.
HOW MUCH CAN I CONTRIBUTE TO MY IRAS?
There is a limit to how much you can contribute to your IRAs each year. For 2023, that limit is $6,500 if you are under the age of 50; if you’re 50 or older, you get the benefit of a catch-up contribution that raises that amount to $7,500. In 2024, those amounts will increase to $7,000 and $8,000, respectively. These limits apply to what you contribute to all of your IRAs combined, traditional and Roth together.
WHEN CAN I ACCESS MY IRA FUNDS?
Because IRAs are vehicles for retirement savings, there are certain penalties for making early withdrawals.
For a traditional IRA, you can start making penalty-free withdrawals at 59-and-a-half years old. (Withdrawals before then could incur a 10% penalty.) Once you reach age 73 (as of 2023), you are required to take a minimum distribution each year, creatively known as required minimum distributions (RMDs). The amount is determined based on your account balance and the Internal Revenue Service’s “Uniform Life Table,” which basically amounts to your life expectancy. Always be sure to take your RMD, though, because the IRS will assess a 50% tax on any amount you should have withdrawn but didn’t.
For Roth IRAs, you can access the amount that you’ve contributed at any time without penalty or taxes. However, whatever you earn on the account cannot be withdrawn without penalty until you are 59-and-a-half years old. The account must also have been open for five years. Unlike a traditional IRA, though, you aren’t required to take distributions during your lifetime. This can be a great way to set aside money that grows for the benefit of your heirs (who will need to take distributions after they inherit it).
There are some exceptions to early withdrawal penalties. If you need the money for certain medical expenses, qualified education costs, to purchase your first home, or due to death or disability you can withdraw certain amounts of money without the 10% penalty.
WHAT IS AN HSA?
A Health Savings Account, or HSA, is a tax-advantaged savings account used to set aside money for medical expenses not covered by insurance. In fact, HSAs offer triple tax advantages—your contributions are tax deductible, the money grows tax-free, and withdrawals aren’t subject to taxes for qualified medical expenses. In other words, you’re using pre-tax funds to pay for health care costs that you would have needed to pay for anyway, saving you taxes on potentially thousands of dollars.
To open and contribute to an HSA, you need to have a high-deductible health plan (HDHP), not be covered by other insurance (including Medicare), and a few other requirements as listed on the IRS website.
Typically, you’ll be given a debit card that draws on your HSA funds for applicable medical expenses.
HOW MUCH CAN I CONTRIBUTE TO MY HSA?
The annual limit for contributing to your HSA in 2023 is $3,850 for an individual and $7,750 for a family. In 2024, those limits increase to $4,150 and $8,300, respectively. If you’re 55 or older, you can contribute an extra $1,000 each year in “catch-up” funds (similar to an IRA).
However, once you are eligible for Medicare at age 65, you are no longer allowed to make contributions to an HSA.
Some employers will also contribute to your HSA, similar to a 401(k) match. Be sure to examine your company policy and take advantage of this free money!
WHEN CAN I ACCESS MY HSA FUNDS?
You can draw on your HSA funds any time you need them for qualified medical expenses.
As a bonus, your HSA goes with you wherever you go. Whether you change jobs, insurance providers, or retire, you still can access your HSA.
Even better, your HSA can turn into another vehicle for your retirement savings. Once you reach the age of 65, you can withdraw those funds for any purpose, not just medical expenses. Your withdrawals will be taxable at this point, but you won’t incur the 20% penalty for non-medical expenses. You’ll likely be in a lower tax bracket at this point in retirement, so the money you withdraw will face lower taxes than it would have during your earning years.
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HOW SHOULD I USE IRAs AND HSAs?
Each type of account is a useful savings tool for retirement, but each has a slightly different ideal use case.
When to Invest in a Traditional IRA: As mentioned above, your withdrawals from a traditional IRA are taxed, not your contributions. Most people end up in a lower tax bracket in retirement because their distributions are less than their income during their working years. If you expect this will be the case for you come retirement, a traditional IRA probably makes the most sense for your contributions in order to save on taxes.
When to Invest in a Roth IRA: Roth IRAs are the opposite—your contributions aren’t tax-deductible, but your earnings grow tax-free and withdrawals aren’t taxed. This is a solid investment choice in three scenarios.
- Open a Roth IRA if you think you’ll end up in a higher tax bracket in retirement.
- Open a Roth IRA if you want to set aside funds to pass on to your heirs, because you aren’t required to withdraw funds during your lifetime. Your contributions will earn interest, grow for decades, potentially, and only be taxed once it is inherited.
- Open a Roth IRA if you are starting young. Contributions made in your 20’s will grow tax-free for potentially more than 50 years! You won’t owe income taxes on that growth.
When to Invest in an HSA: If you have a HDHP for health insurance, it’s prudent to max out your HSA contributions as much as possible. You save taxes on medical expenses, you never lose access to the money, and you can use the funds in your HSA after age 65 for any purpose (after taxes on your withdrawals).
As with many things in life and finances, it’s good to take a diversified approach. For example, you don’t want all of your funds invested in traditional IRAs, which you can’t access (without penalty) until you’re nearly 60 years old.
This article is an overview of how you can maximize tax savings with these kinds of accounts. Your approach will depend on your particular financial circumstances. This includes your income level, employer benefits, and your goals for retirement—do you want to retire at a younger age or when you’re older? What kind of lifestyle do you envision for yourself in retirement?— among other factors. If you’re not sure what the best investment approach is for you, talk to a financial or tax advisor and find out what makes the most sense for your finances and future.
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