Investors aiming to harness the prodigious tax benefits of HSAs should let their spending horizons dictate positioning.
By Christine Benz | 04-12-18 | 05:00 AM | Email Article

How much does the government want consumers to use health savings accounts to pay for healthcare expenses? 

So much that it has made the HSA the only triple-tax-advantaged vehicle in the whole tax code: you contribute dollars on a pretax basis, your money compounds on a tax-free basis, and withdrawals for qualified healthcare expenses are also tax-free. After age 65, HSA funds can be used for non-healthcare-related expenses, though withdrawals for expenditures other than healthcare will be taxable. 

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

Even if your plan is to run the money through the HSA and pull it out on an ongoing basis to cover healthcare expenses as you incur them, the tax benefit is still valuable. For example, let's say a worker has $3,000 in out-of-pocket healthcare expenses in a year and is in the 24% tax bracket. Assuming she forgos the HSA, she'd need to make $3,720 to come up with $3,000 on an aftertax basis, whereas the $3,000 she puts into the HSA is the $3,000 she takes out (plus any interest she has managed to earn over her short time horizon). 

But like any tax benefit, the tax savings from the HSA really stack up the longer your money is in the account. The HSA "spender" cited above mainly benefits from being able to put pretax dollars into the account and pulling money out without any taxes due. But the HSA saver who invests her money, leaves it undisturbed to grow, and uses non-HSA assets to cover her healthcare outlays can take maximum advantage of the tax benefits. As outlined in this article, the aftertax amount of an HSA account would beat an identically invested taxable account and even a 401(k). 

Of course, the HSA's outperformance assumes that the HSA assets can compound at the same rate as the other accounts--a big question mark given that the investment options through HSAs may carry high fees of different types. That makes it essential to conduct a review of the HSA's investment options before investing money in the account for the long term. If you're using your employer's HSA and find out it's subpar, it's not a lost cause, but you'll need to take action to invest elsewhere. 

Long-term investors in HSAs also need to develop a sensible asset allocation framework for their HSA assets and select investments that fit with their anticipated spending from the account. Finally, if your plan is to leave your HSA undisturbed until retirement--the better to benefit from tax-free compounding--it's helpful to think through where your HSA falls in your in-retirement distribution queue. 

If you're convinced about the benefits of using an HSA as a long-term investment vehicle, here are the key steps to take. 

Step 1: Set aside appropriate liquid reserves.
Implicit in using an HSA as a long-term investment vehicle is having liquid reserves, apart from the long-term investment assets, to cover healthcare expenses when they inevitably occur. After all, if you need to raid stock and bond assets to cover healthcare costs, you won't have control over the timing of those withdrawals; your need for cash could come at an inopportune time to sell long-term assets. 

There are two key routes you can take for covering HSA costs while leaving your long-term investments intact. The first would be to use non-HSA assets--like cash in your plain-vanilla checking or savings account--to cover your healthcare costs as you incur them. If you have the wherewithal to do so, that strategy enables you to maximize the tax-advantaged compounding of the long-term assets in the HSA. 

Alternatively, you could employ a hybrid strategy for your HSA. You steer part of your account to the savings option to cover healthcare costs as you incur them and invest the rest in long-term assets. This approach doesn't harness tax-advantaged compounding to the same extent that investing your whole HSA account in long-term assets would, but it's a decent middle ground. HSA providers generally allow you to split your assets across both the savings option and the long-term investment options.

You can use the previous few years' worth of spending to help guide how much to set aside in liquid reserves, either inside or outside your HSA. Of if you want to play it safe and think about the worst-case scenario, look to the out-of-pocket maximums that the IRS sets for high-deductible healthcare plans each year. In 2018, that's $6,650 for people with self-only coverage and $13,300 for family coverage. (Your own out-of-pocket maximum may be lower; check with your plan.)

Step 2: Do your homework on your "captive" HSA's investment lineup and related expenses.
Once you've determined how much to set aside in liquid reserves, either outside or inside your HSA, take a closer look at the quality of the investment options available through your HSA. Morningstar's research found that most HSAs don't do a particularly good job as both savings and investment vehicles; rather, they tend to fare well at one goal or another. You can see a snapshot report that discusses the major HSA offerings here, or download Morningstar's comprehensive HSA report.

If it turns out that your HSA falls short--either on the savings or investment front--it's not a lost cause. If you're self-employed and have selected an HSA on your own, you can easily switch to another provider. And even if you're using your employer-provided HSA to obtain a payroll deduction, you can periodically transfer the money out to the HSA of your choice, as discussed here

Step 3: Determine asset allocation for long-term assets.
The next step is to think about your spending horizon for your HSA assets and let that dictate how to allocate your long-term HSA dollars across the major asset classes. The Bucket Concept is an intuitive way to guide your asset allocation decision-making. Assets you expect to spend within the next few years don't belong in your long-term account; they should go into the savings option. Assets that you expect to spend within the next three to 10 years can go into a high-quality bond option, where they'll earn more than cash but won't experience the same volatility that accompanies stocks. Assets with a 10-year spending horizon or longer can go into stocks, whether U.S., foreign, or a combination. 

For example, a 40-year-old who's earmarking his HSA for retirement and has enough set aside in cash to cover near-term healthcare outlays can invest the bulk of his HSA in stocks. (Some HSA investment menus feature target-date funds, which can be a solid option for hands-off types who expect to spend their HSA assets in retirement.) Meanwhile, a soon-to-be retiree who expects to spend regularly from his or her account throughout retirement to cover healthcare expenses will want to hold more expenses in cash and high-quality bonds. HSA account holders with more bond-heavy portfolios may also want to consider an allocation to Treasury Inflation-Protected Securities, because healthcare expenses have historically experienced inflation at an even higher rate than the general inflation rate. (TIPS bonds would obviously not reflect that higher healthcare inflation rate, as their inflation adjustments are keyed off of CPI, but they'd be better than nominal bonds in an inflationary environment.)

Step 4: Select the investment options.
Once you've determined your asset allocation, you can turn your attention to investment selection to populate your asset-class exposures. While some HSA investment menus offer everything but the kitchen sink (one featured more than 400 fund choices!), that seems like overkill in the context of an HSA. After all, your HSA assets aren't likely your largest pool of money, so it's unnecessary to diversify into niche asset classes like emerging markets equity or junk bonds, even if they're on offer. My bias is to stick with core large-cap equity and high-quality bond funds rather than dabbling in noncore asset classes with HSA assets. Most of the major HSA providers feature index funds on their menus, which tend to feature lower expenses than their actively managed counterparts. 

Step 5: Develop your withdrawal plan. 
HSA investors with long time horizons can and should take a hands-off approach to their accounts. But as retirement draws near, it makes sense to think about a liquidation strategy for the accounts, based on anticipated healthcare spending needs.

Similar to my Bucket Approach to total retirement portfolios, a retiree could hold one to two years' worth of health expenses in the savings-account option of the HSA, another seven or so years' worth in bonds, and the remainder in stocks.

In addition, retirees will also want to consider how their HSAs fit in with other assets in the distribution queue. Assuming a retiree has multiple accounts to choose from, the HSA should logically come after withdrawals from taxable accounts and traditional IRAs and 401(k)s. That's because HSAs enjoy tax-free compounding and withdrawals are tax-free for qualified healthcare expenses, so it's valuable to hang onto those benefits for as long as possible. Taxable account withdrawals, by contrast, will at a minimum be subject to capital gains taxes on appreciation; they may also incur taxes if they hold investments that kick off taxable income or capital gains during the investor's holding period. Withdrawals from tax-deferred accounts, meanwhile, are taxed at investor's ordinary income tax rates; these accounts are also subject to required minimum distributions, whereas HSAs are not.

HSA expenditures should come before Roth IRA spending in most cases, however. That's because inherited HSAs don't have the same tax benefits that Roth IRAs do. If a spouse is the beneficiary of an HSA, he or she can maintain the account as an HSA and continue to take advantage of those generous tax benefits. On the other hand, if someone other than the spouse is the beneficiary of the HSA, the HSA and its attendant tax benefits cease to exist upon the death of the original HSA owner. That means the inherited amount is fully taxable to the beneficiary. Given those drawbacks, that suggests that HSA owners with a nonspouse beneficiary (or a spouse beneficiary with a limited expected life span) prioritize HSA withdrawals well ahead of Roth IRA withdrawals. 

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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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