Health Savings Accounts (HSAs): The Best Tax-Advantaged Investment
Americans are generally pleased with the quality of the healthcare they receive, but not its cost. Healthcare inflation, while moderating during the previous decade, continues to outstrip overall inflation. In response, employers are asking employees to bear more of their own healthcare costs, and government is increasing subsidies to help.
Health Savings Accounts (HSAs) were established as part of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 and evolved from other pretax healthcare programs. An HSA is a personal savings account funded with pretax dollars that can be used to pay for qualified healthcare expenses. While the Act is best known for providing a Medicare prescription drug benefit, the HSA has become increasingly popular with both employers and employees as the tax benefits have lowered both parties’ healthcare costs.
HSAs can only be funded if they are paired with a High Deductible Health Plan (HDHP). Employers like HDHPs because they carry a lower premium than other healthcare plans including traditional insurance, Preferred Provider Organizations (PPOs), and Health Maintenance Organizations (HMOs). Often employers will make contributions of some of their premium savings to their employees’ HSA. According to the Kaiser Family Foundation’s 2019 Employer Health Benefits Survey, HDHPs now make up 30% of healthcare plans, up from 20% just five years ago, and are expected to continue gaining share.
While employees don’t like the higher deductibles and co-payments of HDHPs, they do like employer contributions and the ability to make pre-tax contributions to help pay for their medical expenses. HSAs have the following features:
Only available with an HDHP. For 2020, HDHP’s must have a minimum annual deductible of $1,400 and maximum annual deductible and out-of-pocket expenses of $6,900 for individual employee coverage. The family coverage amounts are $2,800 and $13,800, respectively. Further, HSAs are unavailable if the employee is enrolled in Medicare, can be claimed as a dependent on someone else’s 2019 tax return, or has coverage from another non-HDHP plan, like from a spouse.
Accounts are owned by the individual employee, not by the employer, so they have rollover provisions like an Individual Retirement Account (IRA).
Employers and employees can contribute $3,550 and $7,100 in total for individual and family coverage, respectively, for 2020. Employees and spouses that are 55 or older can each make $1,000 in additional “catch-up” contributions. The non-employee spouse needs to have their own HSA for their catch-up contribution.
Qualified healthcare expenses include out-of-pocket payments such as medical care deductibles and co-pays, prescription drugs, dental, vision, and hearing aids. HSAs can also be used to pay medical plan premiums including Medicare (but not supplemental policies like Medigap) and a portion of long-term care insurance.
Debit cards and checks are available to pay for healthcare expenses at the point of service.
Unreimbursed contributions can stay in the HSA and accumulate over time. Idle funds can be invested for long-term growth.
Distributions for non-healthcare expenses are taxed at ordinary income rates and are subject to an additional tax of 20% except for those 65 or older, disabled or deceased.
Upon death, if the spouse is the designated beneficiary, he/she will be treated as the account owner. If the beneficiary is not the spouse, the account stops being an HSA and the fair market value becomes taxable to the beneficiary in the year of death.
If you are an employee covered by a HDHP, an HSA should be a part of your retirement planning because the account is triple-tax advantaged:
Contributions from the employer gain a corporate tax deduction while employee contributions are not subject to payroll, federal and state taxes (with some exceptions, like California and New Jersey). These pre-tax advantages are like the treatment of traditional IRA contributions.
Earnings from investing unused contributions are tax-free when disbursed if used for qualifying healthcare expenses. This is like Roth IRA distributions.
Similarly, distributions are tax-free, just like a Roth IRA.
I don’t know of a better tax-advantaged investment vehicle than an HSA. If an employee can pay all or at least some medical expenses with current income or other sources, HSA contributions invested for growth can use the power of compounding to build funds for retirement. How much might be needed? According to an April 2019 analysis by Fidelity Investments, a couple retiring in 2019 at age 65 will spend about $285,000 in healthcare expense in retirement, excluding long-term care which itself could add thousands of dollars of additional need.
What if you have access to both an HSA and 401(k)? I’d recommend you contribute to both, prioritizing first dollar contributions to maximize employer matches for either plan (who doesn’t like giving yourself a raise by saving?). Next, consider favoring the HSA for additional contributions to gain the triple-tax advantage before thinking about traditional or Roth 401(k) contributions.
There are some additional strategies for maximizing your HSA balance. Alongside the HSA, some employers offer another tax-advantaged account called a Flexible Spending Arrangement (FSA). The FSA pre-dates the HSA and allows employees to contribute up to $2,750 in pre-tax dollars to pay for qualified healthcare expenses. FSA accounts are owned by the employer and funds not used during the calendar year are forfeited, except that $500 can be rolled over and used for one additional year. If you have the income, contributions to the FSA could be used for current year healthcare expenses while contributions to the HSA are invested for growth. However, employees need to be careful with FSA disbursements. HSA contributions will be invalidated if FSA disbursements are used to pay for HDHP out-of-pocket deductibles. More information is available from IRS Publication 969.
Healthcare expense disbursements from HSAs do not have a time limit. This leads to another strategy to maximize HSA growth: pay healthcare expenses out-of-pocket, save the paperwork and file for HSA reimbursement many years later after the power of compounding has grown the account. The downside to this strategy is the effort required to keep all receipts and working through any headaches justifying expenses many years later.
The growth of the HSA has caught the eye of investment custodians. According to Devenir Group LLC, in June 2019 there were 26.3 million accounts, up from 6.2 million in 2011. During 2018, $43.5 billion was contributed to HSAs, with $10.2 billion invested. HSA custodians are usually chosen by the employer and make their money from several fee opportunities, including account maintenance charges, debit card processing, interest from investing idle account cash, and investment management fees for bond and equity funds. The best custodians keep these fees low, and if the employee has the choice, we like the Fidelity HSA offering. It has no monthly fees, no minimum cash balance requirement, no debit fee charges and offers a broad array of investments including stocks, bonds, and low-cost index or Exchange Traded Funds (ETFs). Provident has offered an HSA for years and is moving to Fidelity now that it began offering HSA accounts.
HSAs are a great retirement vehicle and if you would like to discuss how they may fit into your investment portfolio we would be glad to help.
Daniel J. Boyle, CFA