Best Practices for Health Savings Accounts

Participation in high-deductible health-care plans, or HDHPs, is growing by leaps and bounds, according to industry trade group America's Health Insurance Plans. More than 13 million people were covered by a high-deductible health-care plan in 2012, according to the trade organization, an 18% increase over 2011 and more than double the number of people covered by such a plan five years ago. A recent Towers Watson survey indicated that 70% of large employers expect to offer a HDHP by 2013, and 7% of employers will offer only a high-deductible plan.

It's easy to see why this pocket of the health-insurance market is growing so briskly: As health-care costs and insurance premiums have skyrocketed, HDHPs, combined with health savings accounts, provide employers with a way to offload some of the burden to their employees. For self-employed individuals shouldering their own health-care costs, high-deductible plans might be the most (or only) affordable option.

For people who can't afford to pay the higher out-of-pocket costs that accompany high-deductible plans, the ascent of this type of health care is an unwelcome development. But in a recent Discuss forum thread on Morningstar.com, several HDHP participants said that they were satisfied with their plans. High-deductible plans typically have lower premiums than traditional health-care plans, which can make them a good deal for people whose health-care needs are limited. (The premium savings exceed the higher out-of-pocket costs.)

An even bigger attraction, at least in the eyes of many Morningstar.com readers, is the tax benefits that come along with investing in health savings accounts, or HSAs, the proceeds from which HDHP participants can use to cover their out-of-pocket costs. Contributions to HSAs aren't subject to tax, investment earnings on the assets in the account aren't taxed from year to year, and withdrawals are tax-free, provided they're used on qualified health-care expenditures. As Morningstar reader Randy_S noted in the recent Discuss forum thread, an HSA "is the only investment that is triple tax-favored."

Yet not all HSAs are created equally. High fees and lackluster investment options are frequent drawbacks and can offset, if not downright negate, the tax benefits. That makes it crucial to do your homework and invest with care. Here are some tips to bear in mind.

Make Sure an HDHP Is a Good Fit
As attractive as HSAs might sound from a tax standpoint, the first step is to evaluate whether a HDHP is a good fit for you because you can't contribute to an HSA unless you have an HDHP as your primary insurance. (That means you couldn't sign up for your company's HDHP even though you're also covered by your spouse's PPO.) Nor can you contribute to an HSA once you've signed up for Medicare. In 2012, a high-deductible plan is one with a deductible of at least $1,200 for individuals and $2,400 for families, with a maximum out-of-pocket expense of $6,050 for individuals and $12,100 for families.

Because health-care expenses are unpredictable and those maximum out-of-pocket costs are big numbers, your first task is to make sure you could afford to shoulder your health-care costs until you hit your plan's maximum out-of-pocket costs. Certain types of preventive care, such as immunizations and cancer screenings, are covered under HDHPs even before you meet any deductible or out-of-pocket maximum, provided your plan meets certain criteria; here's a complete list. And of course, the central purpose of your HSA is to cover those health-care costs as they arise. But until you've built up your funds in your HSA, you should have an amount close to your out-of-pocket maximum set aside in very liquid investments before venturing into an HDHP.

Conduct Due Diligence on the HSA
Assuming you've decided an HDHP is a good fit you, the next step is to evaluate the HSA itself. Insurance companies that provide HDHPs typically team up with a bank for HSAs, but you needn't stick with that HSA provider. If you're using an HDHP/HSA combination on your own, you can evaluate HSA providers at arm's length to find the one with the best combination of attractive yields on savings, low fees, and attractive investment options. If you have an HDHP/HSA through your employer, you too can venture beyond your employer's chosen HSA provider, but doing so will be more cumbersome. (More on this in a moment.)

Pay special attention to fees because HSAs can be larded with them. There are frequently HSA-setup fees, ongoing annual or monthly fees, transaction fees, and fees for using debit and checking features. If fees are charged on a dollar basis--for example, a $40 account-maintenance fee per year, those charges will tend to be less of a drag the more assets you have invested in the HSA. Some HSA fees may be waived if you maintain a certain minimum balance, and those with higher balances may also be eligible for higher yields on the assets in their savings accounts.

Savings account yields vary by provider, but don't expect miracles given the ultra-low-yield environment. If your goal is to build up a significant balance in an HSA over time, be sure to check out the investment options. Some HSA accounts offer only a savings account option, but many providers have teamed up with investment firms for longer-term investments. As with an IRA, HSA assets can be invested in mutual funds and even individual stocks. Morningstar.com can help you review the strength of the available funds, in terms of both quality and costs. But you should also be sure to check the fees you'll pay for the investment account itself. Here again, you might pay transaction fees and fees to maintain an account, and these fees can readily erode any earnings and long-term tax savings from your account.

Understand the Consequences When Venturing Beyond Your Employer's HSA
If the HSA linked with your employer-provided HDHP is lousy, first complain to your company's benefits administrator, providing specific details on its shortcomings, and urge like-minded colleagues to do the same. It's also possible to use another firm for your HSA than the HSA provider your employer selected. But if you use an external HSA provider, the hitch is that your HSA contributions won't be deducted directly from your paycheck; you'll need to direct the money to your external HSA on your own, then deduct those contributions on your tax return.

In addition to being cumbersome, you'll also forgo a tax benefit if you contribute aftertax contributions to an external HSA provider. Although contributions directly to your employer-provided HSA via a pretax payroll deduction aren't subject to Federal Insurance Contributions Act taxation--for Social Security and Medicare--you'll forgo that advantage if you contribute to an external HSA. For those reasons, you might consider sending pretax contributions directly to your employer's HSA provider, establishing a separate HSA with the provider of your choice, then periodically moving money to it. That's complicated, but it will be worth it if your goal is to maximize the tax benefits while also investing well.

Consider Paying Health-Care Expenses Out of Pocket
If you've set up an HSA, it might seem obvious that you'd use that money to pay your health-care costs as they crop up. But because the HSA's triple tax advantage is so beneficial, you might instead consider using aftertax dollars to pay your health-care costs, leaving the money in your HSA to compound and grow over time. The Bogleheads Wiki site includes a helpful discussion of whether to use HSA assets to pay those out-of-pocket costs; the conclusion is that those already maxing out tax-sheltered accounts like IRAs and 401(k)s would be best served by using aftertax dollars to pay for health-care costs.

Let Needs Drive Asset Allocation
Your decision about whether to pay health-care expenses out of pocket or let your HSA assets compound and grow should inform your asset allocation for the HSA. If you're going to use your HSA as a source of ongoing funds for medical costs, you'll want to maintain enough in the savings option of your HSA to meet those outlays before investing in longer-term assets such as stocks and bonds. (Your maximum annual out-of-pocket costs would be a good baseline.) If you're using the HSA as a source of funds for retirement, on the other hand, it will make more sense to invest in longer-term assets like stocks and bonds; your proximity to retirement will determine the asset allocation.

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