If you’re not investing in an HSA, you’re missing out. You’re also far from alone.
In fact, by far and away, the most common Health Savings Account (HSA) holding is cash, and it’s not even close. That’s cash that’s earning measly interest that won’t even keep up with inflation, promising the account holder a negative real return.
An HSA isn’t optimal for everyone, but it’s a wonderful investment account for those who have access and qualify to have an account.
Opening one is step one. Next, you should be sure to invest the money held inside your HSA.
What is a Health Savings Account?
An HSA is a retirement account that can be opened in conjunction with a high deductible healthcare plan (HDHP). That’s health insurance with a “high deductible” of $1,400 as an individual or $2,800 as a family in 2021.
The account is often described as triple tax-free, a unique and amazing feature of an HSA.
First, any money you contribute to the account is tax-deductible. With a maximum contribution of $7,200 (or $3,600 as an individual) in 2021, a high-income professional could save $3,000 or more on taxes each year with a maximum contribution.
Second, the money that remains in the account grows tax-free. Unlike an FSA (Flexible Savings Account), there is no use-it-or-lose-it component or limit as to how much can be rolled over from year to year.
Third, and this is the best part, the money can be withdrawn tax-free to pay for eligible healthcare expenses, of which there are many.
Essentially, it acts like a supercharged IRA for healthcare costs. Money is tax-deductible like a traditional IRA on the way in, and it’s tax-free like a Roth IRA on the way out (as long as you pay for eligible healthcare expenses).
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Two Ways to Use an HSA
People tend to use an HSA one of two ways. You can use it to pay for expenses as they arise or you can save receipts and leave all dollars in the account to grow tax-free for decades with the plan to withdraw all money spent on healthcare over the years later on.
There are pros and cons to each approach. Let’s discuss.
Pay As You Go
With this strategy, you pay for medical expenses with HSA money when the bills come in. The highest deductibles out there are equal to about two years’ worth of maximum HSA contributions.
If you don’t have a lot of out-of-pocket expenses, your HSA balance should still grow most years with this method. If you regularly have costly medical bills, you should probably avoid high-deductible health insurance, anyway, making an HSA non-accessible.
While this approach can be considered suboptimal — you’re not allowing all of your contributions to grow tax-free — it’s what I do. I find it’s easier and it eliminates the possibility of never taking money out tax-free for your healthcare expenses.
One strategy I do employ is to never pay a bill with a check or HSA debit card, which many banks will gladly issue with your account.
Instead, I use a rewards credit card to pay for the expenses, and I reimburse myself from my HSA. That nets me at least 2% back on the medical costs, which is significantly higher than the tax drag of maybe 0.5% that results from not leaving the money in the tax-advantaged HSA.
The second approach used by optimizers is to leave the money in the HSA, saving medical receipts for years and years. There’s no requirement to withdraw the money when it’s spent. One could cash in tens of thousands of dollars worth of receipts at once after 30 years of investing in an HSA.
In many ways, I consider myself an optimizer, but this is one of those situations in which I make a financially less-perfect choice. I don’t like the risks and “hassle” of this approach, although the hassle factor has decreased in recent years.
What risks, you ask? There’s the risk that you lose the paper and/or scanned digital receipts you’ve been saving for years. While you’ll take steps to ensure this never happens given how much money can be at stake, people have lost hundreds of millions of dollars worth of cryptocurrency by losing their paper passwords and/or digital keys.
Additionally, when the time comes to cash in those receipts and reimburse yourself with a massive tax-free withdrawal from your HSA, you may not be capable of doing so. You could lose mental capacity or worse, your life, before that day comes. Your next of kin may not know where or why you saved those healthcare receipts.
Investing Your HSA Balance
Whatever you do with your receipts, if you build up an HSA balance, which is likely either way, don’t do what most people do, which is sit on cash.
The Employee Benefit Research Institute found that only 10% of HSAs that had been open for 10 years had any non-cash investments. At 1 year, it was a paltry 2%, and even at 15 years, only 17% of accounts had any investments in stocks or bonds.
These numbers are mind-boggling. 98% of new accounts are all-cash, and 90% of accounts that have been funded for 10 full years are earning little to no interest.
There is a real opportunity cost to sitting on cash, especially in an account that can quickly reach tens of thousands of dollars. When invested for more than a decade, a six-figure HSA is certainly possible, especially If you’re one who saves receipts.
Most Health Savings Accounts do have a minimum balance that must be in cash, but it’s usually in the range of $1,000 to $2,000, or less than a years’ worth of contributions.
The rest can be invested much like the money in a taxable brokerage account, IRA, or a 401(k). Just like a 401(k), your investment options may be limited to a selection of mutual funds representing a wide variety of asset classes. Target date funds are often an option, as well, and you may have the option to choose your own stocks via a brokerage account option within the HSA.
Why Invest in an HSA
Over time, investing in stocks and bonds allows you to take advantage of compound interest, allowing your assets to grow. Whereas cash will fail to keep up with inflation, U.S. stocks have beat inflation by more than 7%.
In the short-term, stocks and bonds will experience more volatility, but when looking at multiple decades, you’re extremely likely to have a positive return. Even with 2 of the 3 biggest market declines of the last century occurring since the year 2000, $1,000 invested in US stocks (as represented by the S&P 500 index) in January of 2000 just before the dot-com bubble burst would be worth $3,523 today according to the S&P 500 calculator.
What if you end up with far more than you could possibly spend on healthcare? Most of our healthcare dollars are spent towards the end of life, and you can spend HSA dollars on Medicare premiums (Parts B & D) plus Medicare Advantage plans). Yes, Medicare costs money, and those costs can really add up.
Nevertheless, if you do have more HSA money than you know what to do with, you don’t have to spend it all on eligible healthcare expenses. At age 65 and after, you can opt to withdraw the money for any reason at all and spend it on whatever you want with one important caveat.
The withdrawals will be taxed just like a withdrawal from a traditional, tax-deferred IRA or 401(k) when not used to pay for healthcare. If you go this route, the money will be double-tax advantaged like a 401(k) since you already got tax-deductible contributions and tax-free growth, but not triple-tax advantaged as an HSA will be when used to pay for eligible expenses.
How to Invest in an HSA
I like to keep things simple, and this account, while it could grow to be six figures, will still likely be a small portion of your overall investment portfolio.
As such, I recommend choosing one low-cost index fund like a total stock market fund and investing the entirety of your non-cash HSA balance (once you’ve met the cash minimum requirement) in that one fund. If you prefer, you could go with a three-fund portfolio, but for an account like this, I think even three funds is overkill.
Lively gives you access to thousands of no-transaction-fee mutual funds, ETFs, stocks, and bonds offered by TD Ameritrade. Fidelity offers a similarly wide variety of investment options. Any HsA provider should offer feasible, low-cost investment options.
If you plan to grow your HSA balance, which I highly recommend, don’t be like so many others letting their balance languish in cash holdings. If you’re not already, do yourself a favor and start investing in an HSA today.
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Do you invest in an HSA? Do you prefer to spend as you go or save receipts?