A Closer Look at Using a Health Savings Account (HSA) to Save for Retirement

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My initial introduction to Health Savings Accounts (HSA) came a few years ago. The Mad Fientist published an article titled “HSA – The Ultimate Retirement Account”.

After reading his article I filed it away in the back of my mind. I didn’t have access to an HSA while working.

Fortunately, I had highly subsidized medical insurance with a low deductible. To use an HSA, you need to be covered by a high deductible health plan (HDHP).

Still, I felt I was missing out on the benefits of the “ultimate” tax advantaged saving account that could shorten my path to early retirement.

This December, my family switched to an HDHP. I revisited that original article and considered whether an HSA was right for us.

As I went through this process, I found that HSAs do have amazing tax benefits. However, utilizing the HSA to your maximal advantage is not as easy as I first assumed. Let’s look at the positives and negatives to help determine if an HSA is right for you.

Positives of Health Savings Accounts

Let’s first recap the Mad Fientist’s article. There are three key benefits that caused him to dub the HSA the “Ultimate Retirement Account”.

Triple Tax Advantage

The first  advantage of an HSA is the outstanding tax benefit it offers compared to designated retirement accounts that can typically be lumped into one of two categories.

Tax deferred retirement accounts, such as a traditional IRA or 401(k) account, allow you to take a tax deduction in the year you contribute to the account. Your money grows without annual taxation of interest, dividends, or capital gains. You eventually pay tax at regular income tax rates when the money is withdrawn from the account.

Roth IRA or Roth variants of work sponsored retirement accounts require that you contribute after tax dollars to the account. Money then grows without any further taxation and withdrawals are tax free.

An HSA allows for the deduction of a tax deferred account in the year you make a contribution. You may also take the money out without any taxation as with a Roth, as long as it is used for a qualified health expense. And you get the benefit of year over year investment growth without taxation of dividends, interest, or capital gains just as you would with any retirement account.

Minimal Risk

HSAs are different than other specialized tax advantaged savings accounts that come with tight restrictions and serious penalties if savings are not used as intended. These restrictions make use of these accounts risky if you are not certain you will need the full amount saved for the designated purpose.

For example, a Flexible Spending Account (FSA), which should not be confused with an HSA, can be useful to help pay for child care costs or medical costs with pre-tax dollars. But, if you set aside too much money in an FSA in a given year, you will have to forfeit your unused contribution.

Another example is using a 529 plan to save for your child’s college. If you don’t need the money for college and want to take it out of the account, your earnings will be subject to a 10% penalty in addition to any tax consequences.

The HSA comes without these risks. In the worst case scenario, you over save in your HSA and are fortunate enough to reach age 65 without having needed to spend the money on healthcare costs.

In this case, the triple tax benefit is reduced to an ordinary tax deferred retirement account. You withdraw your money to use for any purpose, pay your taxes as you would with a traditional IRA, and face no penalties.

Flexibility and Tax Free Growth

Another interesting point is that you don’t have to withdraw money from the HSA in the year that you incur a medical expense.

As long as you have money to cover your medical expenses out of pocket, you can save your receipts and leave your money in the HSA to grow tax free as long as you want. You can then reimburse yourself later, after enjoying years or even decades of tax free investment growth.

This is an interesting feature for those looking to optimize investment returns in your HSA. 

Negatives of Health Savings Accounts

Health Savings Accounts have excellent features that make them appealing to use as tax advantaged savings accounts to supplement other retirement savings. However, they are not without flaws. Let’s examine a few.

Small Contribution Limits

The annual contribution limit for an HSA in 2018 is only $3,450 for an individual and $6,900 for a family with coverage under a high deductible health plan. Compare this to 401(k) plans with individual contribution limits of $18,500 in 2018.

This means a working individual or couple looking to max out tax advantaged savings could save less than 20% in an HSA compared to what they could save in their 401(k) accounts. 

Any additional options for tax advantaged saving and investing are good. But the small contribution limits mean generally small balances in HSAs. According to Forbes, the average HSA balance is only $9,000. They also report that only 11% of HSAs hold investments other than cash.

This all leads to the next problem with HSAs…

Poor Investment Options

Investing an HSA sounds great in theory. The internet and the index investing boom has made being a DIY investor easier than ever.

Vanguard has driven down investment fees throughout the industry. Others like Schwab and Fidelity have responded, further lowering fees for investors in most arenas.

HSAs are one exception. There are too few people investing too little money for the big boys to compete over HSA accounts. Most HSAs are layered with onerous fees.

This leaves only a few reasonable low cost options to invest an HSA. We’ll look at the best options for investing an HSA in a future post.

Logistical Issues

The idea of allowing your money to grow for long periods of time with the triple tax advantages may sound appealing at first glance. In reality, accumulating a meaningful investment balance would be challenging.

It would likely take a decade of maxing out accounts every year, while not spending any of your contributions on qualifying expenses, and investing aggressively to build a six figure HSA balance.

You need the sustained good luck of not needing to pay any medical expenses. Or, you could pay the medical costs out of pocket, then have to wait to be reimbursed years later after the accounts have grown. This is a valid and legal strategy. But, it involves meticulous record keeping and organization.

For me, simplicity has more value than saving a few dollars, so I would take distributions annually to pay for costs incurred during the year. This means that I want a portion of my HSA in non-volatile assets. This leads to one more challenge of HSAs…

Horrible Interest Rates

Interest rates on HSA accounts are generally lower than you could get at any number of local or online banks. Some are better than others, but there is another problematic trend.

HSAs with the best interest rates tend to be local banks that have poor investing options, or no option to invest at all. HSA providers with the best investment options tend to have horrible interest rates on savings accounts.

My Final Verdict on Using an HSA

Being a personal finance nerd, I was excited to have the opportunity to sign up for an HSA. With a better understanding of practical issues associated with HSAs, I am less bullish.

I ultimately decided that an HSA made sense for our family, so we enrolled in December. We were able to make the maximal contribution for 2017, $6,750. This allowed us to reduce our 2017 tax bill by $1687.50. We were in the 25% marginal tax bracket as a two income family and prior to recent tax rate reductions.

Future contributions will offer less valuable deductions due to our lower retirement income and lower tax rates starting in 2018. We will reevaluate ongoing contributions.

Examine your own situation to see if you are eligible for a health savings account. Then decide if the tax benefits make sense for your personal investing goals.

Next month, we’ll look at the best options for investing an HSA and share how we plan to utilize this tool.

[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. You can reach him at chris@caniretireyet.com.]

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