June 2023 IssueLong scroll reading

The Young Investor’s Secret Weapon: The HSA

By Mark Freeland

Many things in life suck. High on anyone’s list would be:

  1. Health insurance costs
  2. Taxes
  3. Being poor
  4. Ketchup-flavored Doritos. (And you know some mad scientist will have, like, mayo-flavored ice cream in the pipeline next.)

When it comes to Frankenfood, you’re on your own, but there’s major good news about the other three. It’s called a Health Savings Account, and it’s the partner of a High Deductible Health Plan. Between the two of them, you can cut – perhaps dramatically – your health insurance costs, cut your taxes, and build a substantial investment account that can pay for health care now and retirement later.

While there are rules (duh), there are very few catches. We’ll walk you through it.

The TL;DR version

When you’re young, you’re mostly healthy, which makes traditional health insurance an expensive money-loser for you. Your best move might be a lower-cost plan with a high deductible. Those plans would cover normal preventive care (your annual physical, for example) the same as always, but they would give you the responsibility of covering the first $1700 of other care (from acupuncture visits to kidney dialysis) on your own. Good news #1: you’re healthy. Good news #2: you can set up a tax-deductible health savings account to cover the cost. If you don’t spend the money this year, no problem. It rolls over next year and keeps building until you hit 65 and can use it for retirement income.

Health Savings Accounts, in more detail

Health savings accounts (HSAs) are an interesting financial vehicle. They provide taxpayers the ability to get a tax break on healthcare expenses without itemizing deductions and perhaps even serve as a longer-term tax shelter. In the latter sense, they are often marketed as super duper Roths – tax-free upon withdrawal but also tax-deductible when contributing.

Like 401(k)s, they may be offered by employers who sometimes contribute to them. Like IRAs, they may be used outside of an employer plan. Like both 401(k)s and IRAs, they have their own contribution limits, including a “catch-up” provision for older people.

Unlike 401(k)s and IRAs, HSAs are designed with a non-retirement purpose in mind. They are coupled with what are called “high deductible” health plans (HDHPs). HSAs help cover healthcare expenses that insurance doesn’t cover (i.e., “out-of-pocket” costs). That makes HSAs especially helpful with healthcare expenses incurred before meeting a high deductible, which is when one must pay 100% of the charges.

I start below with an introduction to what HSAs are and how they work; then move on to eligibility, i.e., the HDHP requirement and considerations there; then how one might use an HSA for tax savings and/or as a long-term investment vehicle; and finally offer some thoughts on searching for HSAs. Along the way, rules will be mentioned frequently because there are so many rules.

What Health Savings Accounts Are

Reasons for HSAs

A health savings account is a type of account, much like an IRA, that allows one to save or invest money that is tax-sheltered. The money is to be used to pay for medical expenses incurred any time after one opens their first HSA. In order to contribute to an HSA, one must have a high-deductible health plan and only a high-deductible plan. This restriction creates an incentive for people to subscribe to high-deductible plans.

In turn, the theory of high deductible plans is that they encourage people to use healthcare services more judiciously. People receiving healthcare are required to pay their own way until a high deductible is met. The more skin one has in the game, the more carefully one is expected to shop, and the more hesitant one is likely to overuse services. On the other hand, one has limited control over when healthcare is needed, and disincentives to use care even when appropriate do not necessarily encourage making the best decisions about receiving care.

Here is a fairly recent (2017) meta-study concluding that both of these perspectives have merit. Regardless of your opinion of this system, this is what we have to work with.

Contributing to HSAs

The rules for contributing to HSAs are somewhat like IRA contribution rules. One gets to deduct contributions, and there are maximum contribution limits per year. These are adjusted annually for inflation. What is different is that there is one limit for people with an individual HDHP covering only themselves and a higher combined limit for spouses who are instead covered by a family plan. Spouses can split their combined limit between their HSAs in any way they choose.

For some more unusual situations, including ex-spouses and domestic partners, here is a good two page summary of the issues involved.

Employer contributions and employer HSAs

Employers may decide to contribute money to their employees’ HSA accounts. Like employer contributions to a 401(k) plan, this is “free” money. But unlike 401(k) plans, employees are not stuck leaving the money in a poor (e.g., high-cost) plan. HSAs can be transferred at any time. One can wait for an employer contribution and then transfer some money out. Watch out for transfer fees that some plans charge.

Withdrawing money from HSAs

The basic rule is that so long as one can identify a past eligible expense incurred after opening an initial HSA, then one may withdraw that expense amount tax-free. One can look back years or even decades to find an eligible expense. So hold on to those bills and receipts until they are no longer needed.

Generally, eligible health expenses are ones that can be used as itemized deductions. One’s own expenses and those of one’s spouse or dependents all count. A notable exception is that health insurance premiums aside from Medicare premiums are generally not eligible expenses.

One may withdraw money anytime, with or without having matching eligible expenses. If there are no matching expenses, taxes are charged on withdrawals. Also, if one is under age 65 (not 59½), there is also a 20% penalty. So these withdrawals are like early IRA withdrawals, where taxes and penalties depend on age.

High Deductible Health Plans, in more detail

There is no need to go into details on high deductible plans. Suffice it to say they are what they sound like, plans where no coverage (except for preventive care) is covered before one meets a high deductible. However, for 2023 and 2024, these plans are allowed (not required) to offer telehealth services without requiring the deductible to have been met first.

From a planning perspective, it is important to weigh the benefits of an HSA against the costs and risks of a high-deductible health plan. People who are very healthy may benefit from a high deductible plan. If they don’t spend enough to meet even a low deductible, they will not pay more out-of-pocket with a high deductible plan. Conversely, people who have serious problems may reach the out-of-pocket spending limits of any plan; for them, what matters is the total cost (premiums plus out-of-pocket cap), not the size of the deductible.

For everyone else, and that is many of us, it is a balancing act. Consider the tax benefits one receives with an HSA and compare them with the potentially higher healthcare costs one could pay because of the higher deductible.

Everyone assumes that with high deductible plans, at least one gets the benefit of a lower premium. That’s often the case, but not always. Also, don’t assume that plans ineligible for HSAs have low deductibles. Even if its deductible is lower than a comparable HSA-eligible plan, the deductible can still amount to several thousand dollars. So shop carefully.

Uses of an HSA

There are two main types of HSA users: those who use HSAs to pay health expenses as they go along and those who use HSAs as long-term investment vehicles. These are not mutually exclusive, as someone who is in good health may pay expenses out of the HSA while still having money left over for long term investment.

A third type of HSA user is a saver – one who, like an investor, accumulates money but, unlike an investor, prefers cash accounts to investment accounts. It is the same idea, just focused on a different asset class.

Someone using an HSA primarily to pay for current expense benefits by getting a tax deduction for contributions. The money is withdrawn soon, so there is not much growth involved. This class of users is likely more concerned with liquidity, ease of use, low fees, and decent interest than with investment options.

With these considerations in mind, an HSA bank account or brokerage account with a good money market fund are appropriate choices. Ease of use means good record keeping, especially since there may be many transactions as health providers are paid. Also, the ability to pay providers directly (checks or debit cards) is desirable.

Those using HSAs as pseudo-IRAs benefit not only from the initial tax deduction but from tax-exempt earnings like a Roth. For these users, investment options and fees of a provider are likely paramount. Whether the provider requires some money to be kept in a cash account or allows 100% of the account to be invested is also of major concern. Ease of use is not as important, as investors are more inclined to take significant withdrawals as opposed to relatively petty cash to pay healthcare providers.

How to get one for yourself: Fidelity and the rest of the pack

HSA accounts are a niche market. Historically, HSAs offered directly to individuals rather than through employers came with high costs and limited options. When HSAs were created two decades ago, nearly all providers were banks or credit unions. Searching for providers then meant just looking for one offering a decent rate of interest and low or no fees. Later, providers started offering mutual fund investments, though Investment options were limited, much like early 401(k)s.

The landscape changed radically when Fidelity entered the retail market with a “regular,” free brokerage account (including an HSA debit card). Readers here are at least somewhat familiar with Fidelity, and so already know what to expect with this HSA. It serves as a good benchmark, even if one prefers a different provider.

For example, if one wants to invest in Vanguard open-end funds, Fidelity may not be the best provider to use. Buying Vanguard funds is expensive at Fidelity. HSA Equity is a provider offering Vanguard funds while charging 0.36%/year of dollars invested to administer the account. It also requires a customer to keep $500 in a cash account. HSA Authority (recently moved to UMB Bank) offers funds from Vanguard and some other fund families. It charges $36/year to invest in funds.

HSA providers tend to come in three different flavors. One type operates like a bank, offering only cash options. Many of these providers are, in fact, banks and credit unions. None pays great interest. One of the better options is Liberty Federal Credit Union, formerly Evansville Teachers Federal Credit Union. As of June 1, 2023, its HSA checking account yields about 2%, and it has 2-5 year HSA CDs yielding 3.05%

A second flavor offers a menu of fund options, often using institutional class shares. These may or may not come with brokerage windows. Those windows, in turn, may or may not come with additional fees. An example of a provider offering only a fixed list of funds is the aforementioned HSA Authority, now called UMB HSA Saver®.

A highly rated startup that offers a brokerage window as well as a fixed menu of funds is Lively. When it first began, it offered a brokerage account through TD Ameritrade and seemed to be a good competitor for Fidelity in terms of pricing and services. It has switched to Schwab (not a surprise, given that Schwab has purchased TD Ameritrade), but has also added a $24 annual fee to use this brokerage option. Alternatively, Lively gives the option of keeping $3,000 in a cash account to avoid the fee.

The third flavor is a provider offering brokerage services without also offering a separate platform with a “curated” set of funds to choose from. There are few HSA providers of this type. Fidelity is perhaps the only “pure” brokerage provider. A small number of other providers partner with brokerages. An interesting and very new fintech startup is First Dollar. It is generally fee-free, though one should take care not to let it go inactive for more than a year, when a high ($5) monthly fee kicks in. It originally partnered with TD Ameritrade and, as Lively has, or will shortly, transition to Schwab.

Some resources for researching HSA providers are:

The Bottom Line

“Young, dumb and broke” is not nearly as cool as Khalid makes it sound. Pursuing the HDHP+HAS combo might leave you young, smart, and well-funded. And really, how much might it be worth to look at one of your friends with a shocked (shocked!) expression and go, “Dude, you don’t have an HSA? That’s dumber than when you bought that flip phone because it would be you all retro-sexy. If you got your s**t together, I wouldn’t be the one stuck paying for all the pizzas.”

There are many rules involved in using HSAs though they can be summed up as qualifying with a high deductible health plan, contributing no more than the maximum allowed, and pairing each dollar withdrawn with an eligible health expense. Shop carefully for that high-deductible plan. Finally, use a provider that best fits the type of HSA user you are – an investor or pay-as-you-go customer.

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About Mark Freeland

Hi, I’m Mark Freeland and if you read the MFO Discussion Board (as you should), you’ll know me as msf. I too am a personal investor who learned about investing over time, following the adage that if you want something done right, do it yourself. At least if one can. Mathematical, scientific, software background, so analytics come pretty naturally to me. I fell into a CFO role at a four-person startup a few years ago, I think because I was the only one who could open a spreadsheet. Prior to that, I'd been on employee committees (again in small companies) recommending 401k investment options. My hope for the months ahead I might share my thoughts about the mechanics of investment vehicles and new developments as they arise.