Health Savings Accounts (HSA) have been getting a "healthy" amount of press lately and mostly for all the right reasons. It has taken a while - the provisions allowing for HSAs were first signed into law by President George W. Bush in 2003 - but the combination of awareness by account holders, financial advisors, and employers have led to a broad acceptance of just how fantastic of a tool this type of account can be for wealth accumulation.
HSA consulting firm, Devenir, releases two reports every year on HSA usage. The most recent one showed substantial growth year-over-year in aggregate HSA assets as well as HSAs assets that are invested. In short, people are starting to get it, that saving in an HSA when you have one available is a good idea. It's not just account holders that are getting it though, employers and financial institutions are starting to see the benefits of encouraging HSAs as assets, instead of just as transactional accounts. This is for good reason too; Schwab Center for Financial Research suggests that assets in an HSA carry between 33-44% more effective dollars vs. other savings vehicles such as 401(k)s and taxable investment accounts, due to the myriad tax benefits.
As a quick recap, HSAs are simply awesome. They allow for tax savings that literally no other account type can boast. For that reason, it is a general rule that if you have access to save in one you should make nearly every effort to max it out.
With all that being said, there are other things to address regarding HSAs beyond just trying to put money into them.
What you'll find below are some tips, tricks, and how-to items on this subject that may amplify your efforts. We'll be covering:
How to max it out if you can't actually afford to contribute
When to start investing your HSA assets
Using it as a pass-through for tax savings
Long-term tax maneuvering
1.) How to max it out if you can't actually afford to contribute the max
As good of an idea as it is to max out your HSA every year, it's also true that many people just plain can't afford to do so. Let's say you're making $60,000 a year, your employer matches your 401(k) on your first 5% of contributions, you are legally allowed to fund an HSA up to $6,900 in 2018, and, finally, you've determined that you are able to save a maximum of 10% of your pay between the different account options. Well, you're not going to (nor should you) skip out on the 401(k) match. So $3,000 (5% of $60k) is going to the 401(k). That leaves you with another $3,000 to save. Let's say you accept that the HSA is the next best place to save. Well, unfortunately you don't have enough to max it out, not even close actually. If you put the remaining $3,000 of dedicated savings in your HSA you still have room to contribute another $3,900.
Well, here's where the trick comes into play. Full disclosure, the following won't work for everyone. The IRS allows a one-time (that's one-time in your life) transfer from a pre-tax retirement account to an HSA up to the contribution limit. So let's say that you have an old 401(k) or Traditional IRA sitting out there. In our made-up situation, you could take $3,900 of that retirement account and transfer it to your HSA. This is an absolute no-brainer decision, though there are some qualifying items to consider, such as: you must be eligible to contribute to an HSA in the year you make the transfer, you can only do this once in your life, and this transfer does not reduce your taxable income like a contribution does.
If you're considering doing this I'd encourage you to wait until the end of the year, that way you can try to make the actual contributions (which are far more valuable than a transfer). Another consideration: there has been substantial legislative discussion over the past year+ on potentially increasing HSA contribution limits. Waiting to execute on something like this may be prudent, if only to see if the effort to increase limits gains steam.
2.) When to start investing your HSA assets
Though prudent usage of HSAs has improved in relative terms, in absolute terms we're still in pretty poor shape. It's estimated that roughly 14% of all HSA assets are invested. That number is low in-and-of-itself yet looks even worse when one considers that only about 6.4% of all accounts are being invested; though admittedly, that data is a bit stale, coming from a 2015 EBRI survey.
This lack of investment action and awareness is actually not too surprising. Most people invest as a result of one or more of the following: investing is a societal norm (as in the case of 401(k)s), guidance from a Financial Advisor, or as a result of automation and/or education from an employer (e.g. most people are automatically invested in the market by their employer in their 401(k)/403(b)). Unfortunately, the HSA investing landscape is too young for it to be "normal" from a societal perspective - there is no herd instinct when it comes to investing HSA assets. Furthermore, most Financial Advisors and employers/plan sponsors are not incentivized to encourage HSA investing. The vast majority of Financial Advisors don't get paid to give advice on HSAs and so they'll rarely talk about it. On a similar note, employers and plan sponsors are generally health focused with it comes to HSAs. They want employees to use HSAs, no doubt, but they want them to use them as transactional accounts in a desire to see employees become more prudent with their healthcare spending with the hopes of keeping health insurance premiums down.
As such, the implementation of HSA investing faces an uphill climb. It'll take proactive efforts by the masses, some professional courage by Financial Advisors, and a different perspective by employers/plan sponsors to make HSA investing more than just a rare occurrence.
But why should we invest our HSA dollars? Well, I can all but guarantee that you will a.) have medical expenses later in life and b.) those medical expenses will be quite high. In fact, Fidelity Investments suggests a couple retiring at 65 will need roughly $275,000 (in today's dollars) just for medical expenses! So you pretty much need to account for this.
Nonetheless, here are a few tips on how and when to invest:
- General rule: keep enough in a cash or money-market position to cover your deductible. Full disclosure: I don't do this; I invest every dollar possible. However, I have a longer-term plan in place. Unless you're working either independently or with a Financial Advisor on a more holistic implementation you should probably just keep enough in cash to cover the deductible.
- Use a bucket strategy. What you do here is separate out your potential expenses and time-frames for those expenses and then invest appropriately. So you'd start with your max-out-of-pocket for the current year and invest very conservatively with that amount. Next you'd take the max-out-of-pocket amount for the following year and invest slightly more aggressively. Then more aggressively with your year 3 amount, so on and so forth.
- Seek help. Investing in your HSA is not as simple as investing in a 401(k), where using a target date fund can be wholly prudent (though I'd argue often times imperfect). Ask your Financial Adviser for help - though if he/she has never independently brought up HSA investing to you then take his/her advice with a grain of salt, as that probably means HSA investing is not in his/her wheelhouse, so to speak.
- Diversify! Diversifying your investments is almost always a good idea anyway, but when the possibility exists of needing the assets in the near-term - as is the case with HSAs - then it becomes an absolute must.
This subject of HSA investing really deserves its own post, so be on the lookout in the future as I hope to tackle it soon.
3.) Using it as a pass-through for tax savings
I recently had a discussion with a married couple about HSAs. They told me that they rarely put anything in theirs beyond what the employer puts in, stating they just couldn't afford to. However, it also came out that when they had medical expenses beyond the amount that the employer put in they would just pay out of pocket. They were doing this without contributing those dollars to the HSA first.
Here's why that's highly inefficient (read: an unfortunate waste of money).
How they were doing it (using made-up dollar amounts):
Taxable Income: $75,000
Income Taxes: $10,733 (assuming 5.33% effective Federal rate, 1.33% effective state rate, 7.65% FICA)
Net Income: $64,267
Medical Expenses: $4,000
Net Income After Taxes and Medical: $60,267
Here's how they should have done it:
Contributions to HSA: $4,000
Taxable Income: $71,000
Taxes: $9,267 (Assuming 15% Federal, 5% State, 7.65% FICA *deductions are always saved at the top-dollar marginal rate, not effective rate)
Net Income After Taxes and Medical: $61,733
So you may be wondering, "I thought that they couldn't afford to save in an HSA?" Well, yeah, but obviously they were paying for their medical expenses so they were scrounging up the dollars somehow, so I assume what they meant was that they couldn't or weren't willing to consistently fit HSA contributions into their budget. With that being said, what they should have done is simply taken those dollars that they found when the medical expenses occurred, contributed them to the HSA, and then immediately distributed them from the HSA to pay for the medical expenses. Nothing would have changed except by funneling the dollars through the HSA they would have (in my completely made-up scenario) saved roughly $1,500.
4.) Long-term tax maneuvering
Did you know you can retroactively reimburse yourself, tax-fee, for medical expenses? Meaning, if you pay for medical expenses out of pocket while having HSA assets (not using the HSA for those medical expenses), you can, at any point in the future, reimburse yourself for those prior expenses completely tax and penalty free. There are some nuanced rules to this, of course (such as retaining proof of payment), but the possibility of this raises some incredible long-term tax planning opportunities. Included in this is structuring future income sources between HSA, pre-tax 401(k), Roth, taxable investments, rental property income, and even Whole Life Insurance so as to limit, and potentially even have zero, income taxes in retirement.
What if you could "save" enough tax-free HSA distributions to cover an entire year's income?This could allow for massive low-tax or tax-free Roth conversions and/or low-tax or tax-free capital gain recognition. This would then domino into future retirement years, allowing for further Roth conversions, capital gains advantages, lower Medicare premiums, and possibly even getting Social Security income tax-free. This would all start by using the HSA the right way today.
Much like the investing point above, this topic deserves its own post (maybe even its own book) but at the very least it's important to be aware of, thus its inclusion here.
It truly is an exciting time to be accumulating wealth; the stock market has been on a nearly decade-long run, taxes were just reduced for nearly everyone, unemployment is extremely low, and people are saving earlier and in larger amounts than ever before. With all that being said, even though we all have a lot going for us as a result of external forces, taking proactive steps towards bettering your situation at the margins will likely result in exponential increases in your future wealth and, quite frankly, much of that marginal value can be found by planning your HSA usage the right way, right now.