California HSA or 401k

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Amhenn01
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California HSA or 401k

Post by Amhenn01 » Wed Dec 06, 2017 3:14 am

I have seen many post about HSA vs 401k, but still can’t seem to understand which is better in California since HSA doesn’t get a state deduction.

Scenario 1
Contribute 15k of Income to 401k and max out HSA

Scenario 2
Max out 401k and non in HSA.

From a California perspective when would HSA ever be better than 401k as an investment tool?

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FiveK
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Re: California HSA or 401k

Post by FiveK » Wed Dec 06, 2017 8:44 am

Here is one way to look at it, assuming
- the HSA is used to pay medical expenses, and thus is federally tax free
- 25% federal and 9.3% CA tax rates.

"Growth" is Future Value (see Excel's FV function) divided by Initial Amount. E.g., for a 5% annual return for 33 years, Growth = 5.
"CA_taxable_Growth" is similar to "Growth", except the Future Value is decreased by the tax drag on annual dividends and withdrawn capital gains. See Formula for dividend tax drag? - Bogleheads.org. For a 5% annual return for 33 years, with 3% annual growth, 2% dividends, and 9.3% tax on both dividends and LTCG, CA_taxable_Growth = 4.5.

401k: $Amt * Growth * (1 - 25% - 9.3%) = 0.657 * $Amt * Growth
HSA: $Amt * (1 - 9.3%) * [CA_taxable_Growth] = 0.907 * $Amt * [CA_taxable_Growth]

HSA / 401k = 1.38 * CA_taxable_Growth / Growth

HSA is better if CA_taxable_Growth / Growth > 0.724. For investment growth due primarily to capital gains not taxed until withdrawal, in practice this will be ~"always". Different assumptions may produce different results.

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grabiner
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Re: California HSA or 401k

Post by grabiner » Wed Dec 06, 2017 10:17 pm

Amhenn01 wrote:
Wed Dec 06, 2017 3:14 am
I have seen many post about HSA vs 401k, but still can’t seem to understand which is better in California since HSA doesn’t get a state deduction.

Scenario 1
Contribute 15k of Income to 401k and max out HSA

Scenario 2
Max out 401k and non in HSA.

From a California perspective when would HSA ever be better than 401k as an investment tool?
Welcome to the forum!

The benefit of the HSA is that expenses are tax-free when withdrawn. The 401(k) withdrawals will be taxed, both federally and in CA if you still live there.

You didn't list your CA tax rate, so I'll assume 6%, which is a common rate for CA taxpayers in the 15% federal bracket.

For $2933 out of pocket, you can contribute $3450 to your HSA, or $3712 to your 401(k). The HSA will let you spend $3450, or if it doubles in value before you spend it, it will let you spend $6900. The 401(k) will let you spend $2933 if it doesn't grow, or if it doubles in value to $7428 before you spend it, it will let you spend $5866 after tax.

If you aren't maxing out a Roth IRA, you could contribute $2933 there for the same $2933 out of pocket; this would let you spend the same $2933 if it doesn't grow or $5866 if it doubles.

Note that CA taxes gains in your HSA. Therefore, if you are investing your HSA (because you have more than you need for current expenses), you probably want to invest your HSA in Treasury bonds or TIPS, as they are exempt from CA tax. This will reduce both the risk and return of your HSA, so you would compensate by holding more stock in your 401(k) to get the right risk level for your portfolio as a whole.
David Grabiner

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grabiner
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Re: California HSA or 401k

Post by grabiner » Wed Dec 06, 2017 10:26 pm

FiveK wrote:
Wed Dec 06, 2017 8:44 am
"CA_taxable_Growth" is similar to "Growth", except the Future Value is decreased by the tax drag on annual dividends and withdrawn capital gains.

HSA is better if CA_taxable_Growth / Growth > 0.724. For investment growth due primarily to capital gains not taxed until withdrawal, in practice this will be ~"always". Different assumptions may produce different results.
And the most favorable assumption makes the growth equal (except for expense differences), with the HSA used to hold your TIPS. The CA tax on a TIPS fund will be zero unless the fund distributes capital gains. And any capital gains will be only the result of small price changes caused by changes in TIPS rates; the inflation adjustment is taxed as a dividend which is CA tax exempt.

If you don't want TIPS (say, because you will have an inflation-adjusted pension, or have a large mortgage which you are paying in nominal dollars), ordinary Treasury bonds work just as well.
David Grabiner

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FiveK
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Re: California HSA or 401k

Post by FiveK » Wed Dec 06, 2017 11:29 pm

grabiner wrote:
Wed Dec 06, 2017 10:26 pm
The CA tax on a TIPS fund will be zero unless the fund distributes capital gains. And any capital gains will be only the result of small price changes caused by changes in TIPS rates; the inflation adjustment is taxed as a dividend which is CA tax exempt.
Just checking: the CA tax exempt quality results from the fact the income is from a federal bond, not that it is a dividend - in other words, CA taxes "normal" dividends as ordinary income - correct?

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grabiner
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Re: California HSA or 401k

Post by grabiner » Wed Dec 06, 2017 11:32 pm

FiveK wrote:
Wed Dec 06, 2017 11:29 pm
grabiner wrote:
Wed Dec 06, 2017 10:26 pm
The CA tax on a TIPS fund will be zero unless the fund distributes capital gains. And any capital gains will be only the result of small price changes caused by changes in TIPS rates; the inflation adjustment is taxed as a dividend which is CA tax exempt.
Just checking: the CA tax exempt quality results from the fact the income is from a federal bond, not that it is a dividend - in other words, CA taxes "normal" dividends as ordinary income - correct?
This is correct. CA does not charge tax on Treasury bond dividends, nor on the portion of a mutual fund dividend which is from Treasury bonds if the fund holds at least 50% bonds exempt from CA tax. (The 50% rule means that Total Bond Market Index is fully taxable in CA.)
David Grabiner

Amhenn01
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Re: California HSA or 401k

Post by Amhenn01 » Fri Dec 08, 2017 11:35 am

Thank you for the help in understanding.

What are you opinions on paying for Medical expenses out of pocket, Submitting for reimbursement, and moving that money to a Roth IRA. This effectively produces the same results as an HSA(For Investment purposes) without the taxation of growth in CA.


Correct?

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grabiner
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Re: California HSA or 401k

Post by grabiner » Fri Dec 08, 2017 9:53 pm

Amhenn01 wrote:
Fri Dec 08, 2017 11:35 am
That are you opinions on paying for Medical expenses out of pocket, Submitting for reimbursement, and moving that money to a Roth IRA. This effectively produces the same results as an HSA(For Investment purposes) without the taxation of growth in CA.
This (or equivalently to write checks on your HSA to pay the bills) is the right way to use an HSA if you aren't maxing out your retirement accounts, even without the CA tax issue. If you pay a $1000 medical bill from your bank account and leave $1000 in your HSA, you can withdraw $1000 tax-free from the HSA in the future, but any gains can be used only for medical expenses. If you pay a $1000 medical bill from your HSA and deposit the $1000 from your bank into a Roth IRA, you can withdraw $1000 tax-free, plus the gains on that $1000 for any purpose in retirement. In addition, HSAs tend to be more expensive.

If you are already maxing out your retirement accounts, it makes sense to leave the HSA intact in order to get tax-free growth.
David Grabiner

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