They offer triple tax benefits but pose investment and planning challenges.
Health savings accounts, or HSAs, get plenty of attention in the financial media and in Washington. Given all the hubbub, it may come as a surprise that assets in HSAs aren’t all that impressive: Just $37 billion was stashed in the accounts at the end of 2016, according to HSA consultancy Devenir. For a bit of perspective, that’s about the size of a large mutual fund.
Yet there’s no denying the growth of this account type, which has mirrored the uptake of highdeductible healthcare plans in the marketplace and on employer-provided healthcare menus. More than 30% of employees are now covered by high-deductible healthcare plans and in turn are eligible to save and invest in an HSA. Assets in HSAs have risen accordingly, more than tenfold over the past decade, according to Devenir.
With that growth comes an increasing recognition that HSAs can be valuable components of individuals’ savings tool kits, especially for those who can afford to pay their actual healthcare expenses out of pocket while leaving their health savings account assets in place to grow. To date, just a fraction of the total assets in HSAs—$5.5 billion in 2016—is stashed in long-term investment accounts; the bulk of HSA assets are parked in savings and checking accounts so that investors can use the funds for out-of-pocket healthcare costs as they incur them.
But because the accounts offer three tax benefits— tax-free contributions, tax-free compounding, and tax-free withdrawals for qualified healthcare expenses—they’re particularly advantageous for investors who can use their HSAs as long-term investment vehicles. If investors are able to pay out of pocket for healthcare costs and allow their HSA accounts to grow, the HSA assets can better harness the power of compounding, and the tax benefits are also more valuable when stretched over a longer period of time.
Investors need to do their due diligence before they employ an HSA as a long-term investment vehicle, though. As you’ll read in the following article, much of what HSA plans offer investors are high costs and poor investment options—although a few plans do earn positive assessments for their investment side. The article is based on a first-of-its-kind study in which we aim to shine the light on the merits of HSAs as both pay-as-you-go savings accounts and long-term investment vehicles.
In addition to gauging HSA quality, long-term investors need to consider the logistics of managing their HSAs, especially if their plan is to carry the HSA assets into retirement. How should HSA assets be allocated during retirement? Where in the retirement-funding queue do these accounts belong? And importantly, what happens to an HSA if the accountholder were to pass away before spending all the money? These are all valuable considerations for investors who are using HSAs as part of their longterm retirement program, not as vehicles to spend as they go.
Let It Grow
The starting point for investors thinking about how to invest their HSA is to consider when they would actually spend those monies. As noted, HSAs enjoy triple tax-advantaged status, and the benefits of that tax-free compounding increase the longer the money is invested. To use a simple example, let’s say an investor contributed $6,000 to her HSA and earned a 5% annualized return over the ensuing 10 years. She’d have nearly $10,000 at the end of the 10-year period, and she wouldn’t owe any taxes along the way—not on contributions, growth, or withdrawal, provided she uses the funds for qualified healthcare expenses.
Meanwhile, an investor who used aftertax dollars to contribute to a taxable brokerage account would steer $4,500 into the account—the $6,000, less taxes, assuming she’s in the 25% income-tax bracket. Assuming a 5% annualized return on her money, she’d have $7,412 in the account 10 years later. She’d then take a tax haircut on the appreciation when she pulls the money out; assuming a 15% capital gains rate, her take-home return would be less than $7,000.