US 401(k) and HSA: America's Two Best Payroll Deductions

The United States taxes salary lightly compared with most of western Europe but offers very little in the way of ordinary deductions, particularly since the standard deduction was raised and most taxpayers stopped itemising.

What remains are the payroll linked accounts, and two of them are worth serious attention.

The 401(k)

• Traditional contributions are deducted from taxable wages, reducing federal and usually state income tax in the year of contribution. Withdrawals in retirement are taxed as ordinary income.
• Roth contributions are made from after-tax income, and qualified withdrawals including all growth are tax free.
• Contributions do not reduce FICA wages. Social Security and Medicare are charged on the full salary regardless, which distinguishes the 401(k) from a British salary sacrifice arrangement.
• Employer matching is the single largest feature. A typical match of a percentage of salary is an immediate return that no investment produces.
• Annual limits apply to employee deferrals, with an additional catch-up amount from age 50 and an enhanced catch-up in the early sixties.

The decision between traditional and Roth follows the same logic as the Canadian RRSP and TFSA choice: traditional wins if your marginal rate now exceeds your expected rate in retirement, Roth wins if the reverse. The Canadian version is in RRSP and TFSA.

The health savings account

An HSA is available to anyone covered by a qualifying high deductible health plan. Its tax treatment is unique.

Nothing else in the American system escapes tax at all three stages. Making the contribution through payroll rather than directly is what captures the FICA saving, which is worth an additional 7.65% and is frequently missed by people who fund the account themselves.

Unlike a flexible spending account, HSA balances roll over indefinitely and belong to the individual rather than the employer. Treating it as a long term investment account rather than a spending account, paying current medical costs from other funds and letting the balance grow, is the strategy that extracts the most from it.

The priority order

1. Contribute enough to the 401(k) to capture the full employer match. Nothing else comes close.
2. Fund the HSA to the annual limit if eligible, through payroll.
3. Return to the 401(k) and increase contributions towards the annual limit.
4. Consider an individual retirement account, subject to income limits on deductibility and on Roth eligibility.
5. Taxable investment accounts after that.

What this means when leaving the United States

Retirement accounts can generally be left in place after departure and continue to grow untaxed under US rules. What the new country of residence does with them is a separate question, and treaties vary in how they treat foreign pension arrangements.

Some countries recognise a 401(k) as a pension and defer taxation until withdrawal. Others tax growth annually or treat the account as an ordinary investment. This should be established before moving rather than after, and the general principles are in retiring abroad and pension tax.