Health Savings Account: A Tax Efficient Investment Alternative?

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Want to take away the pain of paying medical bills? A health savings account may be able to do that. A health savings account, or HSA, is a tax-advantaged way to reimburse yourself for medical expenses, similar to a flexible spending account (or FSA). But unlike the flexible spending account, the balance in an HSA accrues year after year and is never forfeited if it goes unspent in a given year.

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How does an HSA work and does it make for a good alternative investment for your portfolio? Let’s dive into the details.

Understanding the Health Savings Account

For those unfamiliar with the HSA, here are the basics: To contribute to an HSA, you must be enrolled in a qualified high deductible health insurance plan. If your employer offers the HSA, your HSA contributions may be withheld from your paycheck.

If you set up your own HSA with a custodian of your choosing, you’re responsible for making those contributions. The maximum contribution amounts for 2019 are $3,500 and $7,000 for family coverage. Those age 55+ can contribute an extra $1,000 per year.

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Contributions to an HSA reduce your taxable income in the year they are contributed. For contributions made through your employer, you also avoid the 7.65% Social Security and Medicare payroll taxes. For contributions you make on your own, your tax savings are limited to reducing your taxable income by $3,500 for singles and $7,000 if you have family coverage.

When HSA funds are withdrawn to pay for qualified medical expenses, the withdrawals are completely tax-free and penalty-free. Once the HSA account owner reaches age 65, funds can be withdrawn to pay for any type of expenses, however, withdrawals for non-medical expenses will be treated as ordinary income and subject to tax (but not penalties, as long as the HSA owner is 65+).

Using a Health Savings Account as an Investment Account

The basic use of the HSA is to cover your out-of-pocket medical expenses from year to year. A lesser-known use of the HSA is as a long-term tax-advantaged investment vehicle. Most HSA’s come with a cash account as the default savings option where you could earn around 1% interest per year. Many custodians allow the account owner to move their HSA balance into a variety of investment choices similar to what is available in a typical IRA.

The trick to using an HSA as “another investment account” comes from the reimbursement rules. Qualified medical expenses can be reimbursed out of the HSA at any time, even years or decades after the medical expense is incurred.

This feature allows the HSA account owner to grow the HSA’s balance year after year completely tax-free. In retirement (or in a financial emergency), the HSA owner can withdraw from the HSA without paying taxes or penalties on any amount up to the total lifetime medical bills paid since the HSA was opened.

I’ve personally used my HSA as an additional investment account to help fund my early retirement. By making the maximum family contributions for seven years and getting modest investment returns, we’ve managed to accumulate $55,000 in our HSA.

I have a stack of paid medical and dental bills in a file cabinet that sums to $8,000. That means I can take an $8,000 tax-free and penalty-free withdrawal whenever I want.

I can also pay any unexpectedly large medical bills out of the HSA without worrying about the tax impacts of drawing on an IRA or 401k (where most of my money is held). My expectation is that the HSA account balance will continue to grow enough to fund our out-of-pocket co-pays and deductibles for many years or decades to come.

Choosing an HSA Custodian

If your employer provides an HSA option, you can have your HSA contributions withheld from your paycheck and avoid 7.65% payroll taxes on those contributions. Check to make sure your employer’s HSA plan doesn’t have extremely high account maintenance fees or really poor investment choices. If the employer’s plan isn’t great, or your employer doesn’t offer an HSA at all, you can choose an outside custodian to hold your HSA funds.

To choose your own HSA custodian, take a look at custodians that offer investment options. There are a lot of choices in the HSA marketplace like Health Savings Administrators and HSA Bank.

Health Savings Administrators charges a $45 annual fee while giving you access to a good selection of low-cost Vanguard mutual funds.

The annual fee at HSA Bank is only $30 (waivable if you keep at least $5,000 in their low-interest rate savings account), however, the investments are held through TD Ameritrade where you may incur additional brokerage fees.

Downsides to an HSA

With an HSA, the tax savings and potential for long-term investment growth are huge. The main downside of the HSA is dealing with the administrative hassle of tracking medical and dental spending and keeping the bills and receipts.

I tackle this chore by sticking all the bills and receipts in a file box during the year. Then each January, I spend an hour or two with my trusty spreadsheet to summarize the medical expenses paid during the previous year. Then the receipts and a print out of the spreadsheet go into the “HSA expenses” folder in my file cabinet.

So far, two hours of recordkeeping per year has been a reasonable cost to participate in the HSA, given the huge benefits.

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