The Little Saving and Investing Engine that Could
One of the biggest concerns to most people is how to pay for expected or unexpected medical costs. Medical costs are a significant contribution to many bankruptcies in the United States. We can’t realistically plan on staying healthy our whole lives to avoid paying for medical treatment.
One of the juiciest tax breaks out there is the humble and shy Health Savings Account or HSA. Most people have either not heard of it or confuse it with its older sibling, the Flexible Spending Account or FSA. HSAs and FSAs share several common features including tax advantages on contributions and withdrawals that are used for covered medical procedures. They can reduce one’s taxable income while at the same time allow folks to set aside money for medical treatments.
FSAs have the significant limitation that they can only be used during a calendar year and any left over funds are forfeited at year end (or in some cases $500 can be rolled into the following year). They do have one advantage that the entire contribution for the year can be used before all of the money has been contributed. If one wants to put in $2500 for the year and has surgery or other medical expense in January, that whole $2500 is available to cover the cost immediately.
Health Savings Accounts on the other hand, must be used with a High Deductible Health Plan (HDHP). Current IRS contributions limits for 2017 are $3400 for self-only and $6750 for a family (plus $500 or $1000 catch-up contribution if over 55). HDHPs and HSAs might not be the ideal plan for people with chronic diseases, unfavorable genetic histories, high prescription drug costs or for those who expect to have a baby if lower deductible plans are available. On the other hand, for those whose only options offered through their employer are high deductible, HSA-eligible plans, who have no large anticipated medical costs in the coming year it’s an easy choice.
What HSAs Were Actually Designed To Do
HSAs were signed into law back in 2003 as part of the Medicare Prescription Drug, Improvement, and Modernization Act. They were envisioned to help low and middle income families pay for medical treatments with before tax dollars. HSAs allow people to stash away tax deferred money each year and let it accumulate until a medical expense is incurred. Like many tax advantaged plans, a custodian is required to administer the plan and make sure that there is some accountability and that the law is followed. Custodians do not own the money in the plan, but are required to oversee that the plans are administered according to the law.
By design, HSAs allow anyone with a HDHP to put away money each paycheck toward future medical costs. This money is not subject to federal tax and is usually also exempt from state taxes. If included in a cafeteria benefit plan through an employer, these contributions are also not subject to Social Security and Disability taxes. They provided a juicy incentive to encourage people to save for large medical expenses and not be penalized for that savings, kind of like a 529 plan is to college savings. The hope was that as people became responsible for their medical expenses, they would demand quality care at a fair price. That hope so far has not really materialized. The overall impact of HSAs to the health care system in general is debatable, but not a subject of this post.
The bonus feature that an HSA has is that the money is not taxed coming into the account, when interest or dividends are paid or capital appreciation occurs, or when the money is withdrawn for medical expenses. It is just about the only tax-free money most Americans can get and stay on the right side of the law. Contrast the HSA with the 401k or traditional IRA. Both the 401k and IRA funds allow the participant to contribute money that is tax deferred, that is they don’t federal pay tax (but do pay Social Security) on the contributions until they are withdrawn, at which point they pay the nominal tax rate for ordinary income for any withdrawals. If the money is withdrawn early, i.e. before age 59.5, they also pay a 10% penalty in addition to federal and state taxes.
How to Hack an HSA Became a Primary Emergency Fund and Secondary Retirement Fund
When a qualifying medical expense is incurred, the HSA owner can elect to
a) pay the expense directly with a debit card linked to the HSA account, or
b) request reimbursement through the HSA custodian, or
c) not take any action and let the money sit in the account.
At first glance, option A might appear to be the easiest as it’s the most convenient and for some it might make sense. Option B might be better for those who have a large expense and want to wring out a few additional credit card points or miles out of the transaction. Option C is the best option for those who have sufficient assets to cover the expense and keep the money in the HSA account. Those options are detailed in the figure below.
Let’s dive deeper into the details of Option C above and why it makes an awesome emergency/retirement fund. Many HSA accounts feature an investment option that allows the owner to invest the money contributed to an HSA until such time that he or she needs it for a medical expense. There is no “use it or lose it” constraint like there is for a FSA, so contributions made 5 or 10 years ago can be used to pay for medical care today or in future years, even if the participant is no longer in an HDHP plan.
There is also no requirement that someone reimburses herself immediately for medical expenses incurred. If one determines that she can pay her medical bills from current savings without dipping into her HSA funds, she could just log the expense in Mint or Personal Capital, or a spreadsheet as an expense available for future HSA reimbursement. This amounts to a super tax-advantaged emergency fund: she can invest up to $3400 (single) or $6750 (family) a year in any of the investment funds within the HSA, pay all medical expenses out of pocket and let the investment grow through the years until such time that she needs the money, then withdraw the money needed, provided she’s had at least that amount in medical expenses. The only stipulation is that the expense must have been incurred on or after the year the HSA account was established. She would pay no federal or state taxes on that withdrawal, even if the investment appreciated significantly.
Don’t have a decent selection of investments in your HSA account? No problem. You can transfer HSA accounts to a different custodian to manage, often even while maintaining the current HSA active (check with your custodian or company HR department to confirm). There are a variety of custodian options to consider. Vanguard does not currently serve as a custodian for HSA accounts but have partnered with Health Savings Administrators to manage the accounts that use Vanguard funds. The fees are non-trivial: $45 per year plus 25 basis points ($25 per $10,000 invested) per year on top of the Vanguard expense ratios. If the market returns somewhere in the 7% average range, a $10,000 investment would yield about $625 after the fees listed above included the Vanguard expense ratio. On the other hand, a $10,000 cash investment would only return about $50 per year if left in a cash fund that pays a “generous” interest rate–even a moderate expense ratio investment is better than cash in the long term.
For people in my situation with fund options that range from mediocre to terrible, it doesn’t make sense to switch account custodians when the account is under ~$20,000- when the amount saved from lower expenses is less than the fees charged by the new administrator. The fund with the lowest expense ratio in my HSA is 0.45% or $45 per $10,000 invested-not bad, but not great. For a similar fund serviced by Vanguard, that ratio is 0.05% or 9 times less than my current fund.
As discussed in You Get (to Keep) What You (Don’t) Pay For, one percentage point has a significant impact on future investments, so shaving that cost down as much as possible is recommended. Unfortunately, that expense ratio is artificially low for the Health Savings Administrators HSA account as there’s a 0.25% of total asset charge by the custodian to own this fund, so I’m only saving a minuscule 0.10% and that’s before the $45 annual fee they also impose. At $25,000, my cost each year at the present custodian would be $112.50, but if I transfer that amount, my total cost would be $120, so I probably won’t be switching at least for a few more years. For those with plan options with expense ratios hovering around 1%, that switch would make much more sense.
A word of caution: there are some really bad HSA funds out there-some of the worst in my plan charge 1.5% expense ratio per year plus a 5.75% one-time sales load-an advertising fee that works out to almost 4 years worth of their already sky high expense ratio, or just over one year at 7% return to get back up to the initial contribution amount!
Many HSA administrators offer a range of investments so you can grow your money and keep up with inflation. These plans are a key part of reducing taxes and early retirement strategies, especially if you have income available to cover the medical expenses up front. Essentially, you max out your HSA each year, invest it in inexpensive index funds (if available), pay for all medical expenses out of pocket and record the amounts, and when you absolutely need the money, withdraw what you need, marking your recorded expenses as paid. And, voila! you have created some completely tax free money and all you had to do was have medical expenses.
What happens if you never accrue enough medical costs to withdraw your entire HSA investment? You can start withdrawing from an HSA like you would an IRA at 65 years old. The humble HSA is the best answer to avoiding the $2 = $1 dilemma: you pay no federal income tax, state income tax, social security, or Medicare tax on any contributions to the HSA. Additionally, if you are on an Affordable Care Act medical plan that includes a subsidy, your subsidy will likely also increase as your Adjusted Gross Income decreases, meaning your monthly premium will go down. That, my friends in a tax-advantaged account!