HSAs and retirement plans: employers should tailor their contributions to health savings accounts and qualified retirement plans to ensure they complement rather than cannibalize each other.

Health savings accounts are tax-advantaged accounts designed to pay for qualified medical expenses. While many use their HSA to pay medical expenses as they occur, others are looking to the accounts as a retirement tool.

This is not surprising given that medical costs are a major post-retirement expense. According to the 2004 Employee Benefit Research Institute Health Confidence Survey, an employee that retires at age 65 needs on average more than $100,000 in savings to cover health expenses during retirement. The average American has simply not planned adequately. HSAs offer a solution that will help many close this gap.

Careful planning by the employer, however, is needed to ensure that health savings accounts complement the employer's retirement program and do not compete for the same contribution funds.

Contributions to HSAs are pre-tax, and qualified retirement plans are tax-deferred, and both also accumulate tax-free. But withdrawals are treated differently.

Withdrawals from an HSA to pay for qualified medical expenses are tax-free including earnings, regardless of age. Nonqualified withdrawals, for reasons other than death or disability, are taxed at a participant's normal tax rate plus a 10% penalty if the participant is under age 65. If the participant is over age 65, the penalty is waived, and the withdrawal is subject to normal taxation.

If a participant takes a withdrawal from the 401(k) plan prior to age 59 1/2, it is subject to the normal tax rate plus a 10% penalty, whether a hardship withdrawal or withdrawal for any other reason. Withdrawals under allowable plan terms after age 59 1/2 are subject to normal taxes. There are some exceptions to the taxation on withdrawals for certain large medical expenses, but in most instances, the amount would not qualify.

Although qualified retirement funds may be available without penalty sooner than HSA funds (age 59 1/2 vs. 65), the tax-free withdrawals for qualified medical expenses at any age make them particularly attractive to many plan participants.

Employers may contribute to each plan, but they should understand that discrimination rules may impact the operation of the programs, resulting in unintended consequences if the HSA cannibalizes the qualified retirement plan.

Discrimination rules for both HSAs and qualified retirement plans are intended to ensure that the plans are operated for the benefit of all participants, not just the highly compensated. An exodus of rank-and-file employees from the qualified retirement plan to the HSA can limit the amount of tax-advantaged retirement funds that highly compensated employees can set aside. This can be an unpleasant surprise to the owner and/or highly compensated employee if this was not communicated in advance.

The IRS has allowed employers a great deal of flexibility in how they fired their employees' HSA accounts if a cafeteria plan is used. As a result, many employers are considering using a matching concept, similar to the match used in their qualified retirement plan.

This approach appears attractive on the surface in that it makes communication easier and encourages employees to fund their HSAs and to become more active in their health-care decisions. And lower-compensated employees would likely fred the HSAs attractive. This strategy, however, can cause limitations on retirement savings for highly compensated employees. Fortunately, there are alternate approaches that can make both the qualified retirement plan and health savings accounts a success.

* Employers can match employee health savings account contributions, but less generously than the qualified retirement plan match. This will encourage employees to first fund their qualified retirement plan and then the HSA.

* Employers can contribute a flat dollar amount to employees' health savings accounts while retaining the match for the qualified retirement plan. This allows employees an accumulation for their benefit in both accounts and sets them up to complement each other rather than compete.

* Employers can contribute to the HSA based on employee participation in health-improvement activities such as in wellness or disease-management programs. This would encourage participation in both the qualified retirement plan and health improvement activities.

Careful planning will help employers ensure that both their qualified retirement plan and health savings account are successful. The key is to design programs that complement, not compete, with each other.

Jerry L. Ripperger, a Best's Review columnist, is director of Consumer Health at Principal Financial Group, Des Moines, Iowa. He can be reached at [e-mail].