By Keith Whitcomb

Some financial advisers discourage accumulating assets in a health savings account (HSA) and instead suggest using the HSA to pay for current qualified medical expenses (QME). Others tout triple tax savings and tell clients to pay medical bills out of pocket with after-tax funds to build up the HSA for use in retirement. So, who is right?

Currently only about 4% of HSA account holders invest, so at this point most people are spending. But that may change. HSA assets have been growing over the past 10 years and are projected to reach over $75 billion in 2020. What does that mean for you? If you are one of the 26 million people with an HSA, check to see if the HSA could fit into your financial plans for retirement. To accomplish this, you need to understand if accumulating long-term assets makes sense for you, when investing the HSA for retirement is a good idea, and how those investments should be managed.

Should You Invest Your HSA?

Two things to consider, when evaluating whether investing your HSA makes sense for you, are the impact of HSA deposits on Social Security and how a 401(k) match modifies the decision.

HSA versus Social Security - I was once in a meeting where an adviser insisted that "rank-and-file" workers should never accumulate assets in their HSA, given it would reduce their Social Security benefits. That's because HSA deposits not only avoid income taxes (when used for QME, some exceptions apply in California, New Jersey, New Hampshire, and Tennessee), they also avoid FICA tax when deposits are made as part of a Section 125 cafeteria benefit plan offered by your employer. That means the HSA really offers "quad tax" savings. However, FICA is different from other taxes. It can almost be viewed as a premium payment to purchase an annuity, i.e., Social Security. As a result, it is important to know when the net result of reduced FICA payments on Social Security benefits overrides HSA tax savings. Let's take a look.

  • Income above FICA wage base: If your earnings are above $132,900 in 2019 (net of HSA contributions), then there is no issue with reduced Social Security benefits from avoided FICA. That's because wages above that limit are not subject to FICA. You will get all the "triple" tax benefits of the HSA with no Social Security downside.
  • Income below FICA wage base: This is where the analysis gets a little bit tougher. The classic evaluation of Social Security benefits focuses on an internal rate of return (IRR) calculation designed to give you a breakeven percentage to compare to your other investments. What gets lost here is that Social Security is more than just another investment alternative. It is an inflation-adjusted U.S. government-backed annuity that generates tax-advantaged, perhaps even tax-free, income in retirement. That means, unlike stocks and bonds, it eliminates market, inflation, and mortality risk with potentially no taxes.

In addition, there tends to be a focus on a single IRR when Social Security benefits are evaluated in the media. The issue here is that the calculation is a function of a lot of variables that materially affect the outcome. They include (but are not limited to) how long you live, inflation, investment returns, 35 years of wage history, family status, and future tax rates. And, Social Security has a "progressive benefit structure." For example, average annual earnings below $10,600 are replaced at 90¢/$1, from there up to $69,000 at 32¢/$1, and above that until $118,000 at 15¢/$1. That means a "one-size-fits-all" IRR calculation is not going to reflect your personal circumstances.

However, you can find a more personalized IRR calculation by opening this actuarial note from the Social Security Administration, Internal Real Rates of Return Under the OASDI Program for Hypothetical Worker.

The tables in the document have IRRs that range from 0.47% up to 9.26%. As a starting point, an IRR under 2% likely favors the HSA while above 3% (given the current yield on long Treasuries is hovering around 3%) makes the Social Security alternative look favorable.

HSA versus 401(k) match - While the tax-free HSA can handily beat 401(k) withdrawals subject to ordinary income taxes, what happens when there is a 401(k) match? A general rule is that you should first contribute to your 401(k) and max the match, then max the HSA before making additional contributions to your 401(k). But that depends on your marginal tax rate and the match offered by your employer. Here is a table that identifies when a 401(k) with a match is the best alternative.

When to Invest Your HSA

If it makes sense for you to invest your HSA, you then need to determine when you should invest. From a finance standpoint, you will likely have to balance the need for short-term liquidity with long-term investment opportunities. That's because having a high deductible health plan (HDHP) that enables you to contribute to the HSA ends up having you self-insure a larger portion of your medical expenses. As a result, you need to determine how much cash to have on hand in your HSA to cover that exposure. Here are some things to consider:

Liquidity for planned medical events - This is a budgeting exercise that balances your planned utilization with your health plan's deductibles and out of pocket max. It encompasses known chronic conditions, maintenance drugs, and planned procedures.

Reserve cash for unexpected events - This refers to your ability to financially weather unplanned medical events that push you to your out-of-pocket max. This could involve out-of-network procedures and expenses outside of your plan's covered services, or unfortunate timing. A classic example is having appendicitis on New Year's Eve where expenses fall over two plan years. You are immediately exposed to two times your annual out-of-pocket max over a two-day period.

Alternatives to HSA cash - By building other financial resources outside the HSA, you may be able to invest more of your funds in the HSA. Having an emergency fund, access to a 401(k) loan, or home equity line of credit (HELOC) provides you with sources of backup funding. If you have to use them, you can always reimburse yourself as deposits flow into the HSA. In this way, you will be able to pay down debt or replenish your emergency fund and still enjoy the tax-free benefits of the HSA.

Investing it all - What if you don't need the HSA for payment of any current medical expenses? If you have sufficient financial resources to cover the financial exposures of your health insurance, you can invest 100% of your HSA. If you do, save all receipts from the QME you pay for out of pocket with after-tax funds. The net result is that you maximize the investing benefits of the HSA, and effectively create a cash reserve usable for any purpose based on the cumulative value of the saved receipts.

How to Invest Your HSA

So, if investing makes sense for you and liquidity requirements are satisfied, a final issue to consider is how you should invest your HSA. Two things to think about include the features and fees of the HSA, and the investment strategy.

Account Evaluation - Some HSA products do not offer an option to invest your funds. Others may have a limited menu of investment alternatives. In addition, fees associated with the investments, e.g., transaction, management can be expensive. If your company's HSA provider has these shortcomings, you do have the ability to move your money elsewhere. Unlike the 401(k), your HSA is under your control.

Just like your checking, savings, and brokerage accounts, you can open and close health savings accounts at other institutions, and even have multiple HSAs. You may end up with the account provided by your employer being used for initially depositing funds and liquidity. A second account could provide the lowest fees and best options for your investments. Check with your HR department because your employer may allow you to select the HSA provider for direct deposit of your contributions. Otherwise, you will need information on how to make fund transfers. While inconvenient and subject to fees, if you only need to make the transfer once annually at the end of your plan year, it is likely worth the hassle.

Asset Allocation - The asset allocation strategy for your HSA should be similar to your other long-term accumulation accounts (i.e. risk suitability and asset selection). As you near retirement you may want to prepare the account to handle the liquidity needs of your retirement medical expenses. That will include Medicare and supplement insurance premiums, and potentially an estimate for deductibles and/or copays.

The HSA is likely the only completely tax-free investment opportunity available to you, so if it makes sense, take advantage of it. While the disclaimer "your results may vary" is applicable here, it is likely that investing in the HSA will significantly improve the funding of your retirement.

About the author: Keith Whitcomb MBA, RMA, is the director of analytics at Perspective Partners and has more than 20 years of institutional investment experience.