These Accounts Can Multitask for Investors
Health-savings accounts can be used to save for long-term-care costs in retirement, while a Roth IRA can double as an emergency fund or a vehicle for college savings, says Morningstar's Christine Benz.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Investors are often juggling different goals; I'm here with Christine Benz--she is our director of personal finance--to help with the pros and cons of using various investment accounts to handle multiple goals.
Christine, thanks for joining me.
Christine Benz: Jeremy, it's great to be here.
Glaser: Your first idea is potentially using a health-savings account, an HSA, to save for long-term care. How would this work?
Benz: Well, you could use your HSA to fund long-term-care costs in a couple of different ways. One would simply be to say that I'm not going to spend my HSA assets as my health expenses occur; what I'm going to do is let that money build up, I'm going to invest it, and then eventually if my plan is to self-fund long-term-care costs, should they arise, I would be able to use the HSA to fund those expenses. So, the HSA has three really important tax advantages, which really makes it better from a tax standpoint than any other investment wrapper that we have.
So, you have pretax contributions going in, you have tax-deferred compounding, and then you have tax-free qualified withdrawals. So, as long as your withdrawals are for qualified healthcare-related expenses, they will be tax-free as well, and long-term-care expenses count as one of those qualified disbursements. So, I think it's a really attractive strategy.
It can also be an attractive idea for people who have gone ahead and purchased some sort of a long-term-care policy because you can use a certain dollar amount based on your age to actually pay your premiums. So, for people who have purchased a long-term-care policy but are worried about how they will pay those premiums in retirement or are worried about potential premium increases down the line, they can use those HSA assets to pay those premiums as they occur. And again, the amount that you can steer toward those premiums steps up as you age. So, the older you are, the more of your account you can steer toward paying long-term-care premiums.
Glaser: What are the risks of this strategy?
Benz: Well, a couple of key risks. One is that, in order to have an HSA, you need to be participating in a high-deductible healthcare plan. So, the big risk is that if you are needing the money in your HSA, if you haven't set aside external assets to fund your healthcare expenses as they occur, you could end up raiding that long-term-care fund that you were aside in your HSA.
The other risk that I would say, Jeremy, is that when we look across the HSA landscape today, what we see is that a lot of fees are lurking. People may pay transaction costs; there may be added layers of investment-related expenses; there may be investment choices that aren't all that good. So, I would say this strategy is only going to be effective if you have the opportunity to contribute to a good-quality HSA with fairly low costs and good investment options.
Glaser: One of the questions we hear a lot from younger investors is that they know they need to--and want to--start investing but also want to build up an emergency fund. They want to have some cash cushion. How could a Roth IRA help them do both?
Benz: Well, this is one thing I often say in favor of a Roth IRA: It's an ideal multitasking vehicle. One thing people may not realize because they may have seen that there are rules about which disbursements from IRAs qualify--if they are healthcare expenses or first-home purchases and so forth--but one thing to know about Roth IRAs is that your contributions can be withdrawn tax-free and penalty-free at any time and for any reason. So, I think that makes the Roth IRA a really neat idea for simultaneously building up that emergency fund and getting some money working for your retirement plan. I think a side benefit may also be that if you have your emergency fund segregated in a Roth IRA, you may be a little bit less inclined to raid it to take a great vacation or buy a car or whatever it might be. You may be a little more respectful of the fact that you've set those assets aside for retirement, and you may be less likely to raid them prematurely.
Glaser: If you're a young investor, you probably want to have a more aggressively positioned Roth IRA, but your emergency fund probably needs to be pretty liquid. How do you reconcile that?
Benz: That's the big challenge of using this strategy. With an emergency fund, the guideline is that you are keeping that money parked in highly liquid assets--typically cash accounts of some kind. If you are, say, a 20-something, you aren't going to be able to take advantage of that long runway you have for compounding if you are hunkered down in cash. So, for most people, I think it makes sense to start building a baseline in cash investments. Once that cash fund gets large enough to defray some of those costs that might arise--whether healthcare expenses or whatever it might be--once you've got that emergency cushion built up to at least three months' worth of living expenses, then I think you can go ahead and start stepping out on the risk spectrum with that retirement portfolio and start investing primarily in stocks if you are a younger investor.
Glaser: Another use potentially for a Roth IRA is to save for education for your child. What would be some of the tax benefits of doing this versus going with maybe a 529 plan?
Benz: Well, as we just discussed, the contributions that you put into a Roth IRA are able to be withdrawn tax- and penalty-free at any time and for any reason. If you are a parent who is over age 59 1/2 and you've had that Roth IRA account for at least five years, you can withdraw the entirety of your Roth IRA at any time and for any reason without taxes or penalties. So, it's a pretty flexible vehicle from the standpoint of taxes and paying for college.
Glaser: What are some of the other benefits?
Benz: One of the key benefits is that in contrast with 529 plans, which have that layer of expenses--administrative expenses, typically--you can get away with very low expenses inside of a Roth IRA. Assuming that you have some sort of critical mass in your account, you will probably just have any mutual fund operating expenses, but you won't have any ongoing administrative drag. You also have open architecture in terms of what you can invest in, whereas with a 529 menu, you are constrained to a list of choices.
Finally--and I think this is an important one--people who are saving for their kids' education don't really necessarily know what the future will hold. They don't know that their children will go to college. They don't know whether they will get a scholarship that will cover part of their college costs. If, in that situation, your child ends up not needing the Roth IRA for college funding, you can certainly use it for its original intent, which was your own retirement.
Glaser: This is somewhat controversial, though. Why is that?
Benz: The biggie is that by withdrawing money for college expenses, you are starving your own retirement of those assets. So, it's certainly not something to be entered into lightly; you need to make sure that you are well on track to retirement savings before you consider using any part of your Roth IRA to fund college.
Then, another issue relates to financial aid. On the plus side, Roth IRA assets are treated pretty well when it comes to that FAFSA form that parents need to fill out to apply for a financial aid. But on the negative side, withdrawals from your Roth IRA are counted against you on that FAFSA form. So, unless you wait until the very end of college to start pulling money from your Roth IRA, at some point those distributions are going to be begin to weigh on your financial-aid eligibility.
Glaser: Christine, thanks for your thoughts on these multitasking accounts today.
Benz: Thank you, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.