Health-Savings Account: Spend or Invest?

A version of this article originally published in February 2016.

High-deductible health plans have been proliferating in recent years: 82% of large employers planned to offer a high-deductible healthcare plan in 2015, according to data from Towers Watson, up from just 21% of large employers offering an HDHP a decade ago. Health-savings accounts (HSAs), which are used alongside HDHPs to help individuals pay their out-of-pocket healthcare costs, have been growing in prevalence right alongside HDHPs, charting an average annual growth rate of about 15% since 2011, according to a survey by America's Health Insurance Plans.

To help incentivize workers to save for these out-of-pocket healthcare expenses, HSAs offer a three-fer on the tax-break front: Participants contribute pretax dollars to their HSAs, the assets grow on a tax-free basis, and money can be withdrawn on a tax-free basis for qualified healthcare expenses. That nudges the tax-saving features of the HSA ahead of other tax-advantaged retirement-savings vehicles, which are either taxed on the way out (traditional IRAs and 401(k)s) or on the way in (Roth accounts).

Given those tax benefits, some financial planners argue that individuals who have the financial wherewithal to do so should leave their HSAs undisturbed, using aftertax, non-HSA dollars to cover healthcare costs as they occur. That strategy allows the investor to take maximum advantage of the tax-saving features of the HSA, while spending the less-tax-efficient taxable assets.

Few HSA participants use their accounts in that way, however. In a study from HelloWallet, just 4% of HSA holders in the sample group actually invested their HSA assets. The majority of HSA holders, by contrast, either saved their HSA assets in the savings-account option or spent the HSA money on an ongoing basis to cover healthcare costs. Just 5% of HSA holders in the study contributed the maximum allowable amount to their HSAs. (In 2017, it's $3,400 for individuals and $6,750 for those contributing to an HSA for a family.)

Perhaps some of that resistance owes to the fact that many HSA owners don't have the financial wherewithal to use their HSAs as a supplemental savings vehicle. For such investors, the HSA offers a practical and tax-advantaged way to cover healthcare costs without having to raid emergency assets or resort to unattractive forms of financing like credit cards.

Meanwhile, investors who do have the financial assets to pay healthcare expenses out of pocket while leaving their HSA assets intact may avoid doing so due to mental accounting. Even though the HSA offers tax benefits that grow even more valuable with compounded interest over time, using an HSA to cover healthcare costs as they arise is convenient and doesn't disrupt the household's normal cash flow.

Finally, at least some of the resistance to investing HSA assets is likely a purely rational response to the fact that many HSAs are larded with costs and don't necessarily feature best-of-breed investment options; those disadvantages can erode the tax benefits of the HSA.

Tax Benefits of HSAs Stack Up First, let's take a look at the base case in favor of using an HSA as an investment vehicle. In the illustrations below, I'm considering just the tax issues--not the fact that some HSAs might have more costly investment options than an investor could find by investing in a taxable account or 401(k) plan. (I'll consider those later.)

Assuming a participant in the 25% tax bracket contributes the maximum family contribution to an HSA--$6,750 in 2017--and does so for 30 years, earning a 4% annual return, she'd have $378,573 at the end of the period. She could use that money to cover healthcare costs in retirement, and the qualified withdrawals would be tax-free. If she needed the money for nonhealthcare expenses in retirement, she'd pay ordinary income tax on her withdrawals. (Note that a handful of states tax contributions or investment earnings; here's a listing of HSA treatment by state.)

By contrast, if she used her HSA assets to fund her out-of-pocket healthcare costs and steered her investment dollars to a taxable account instead, her taxable assets wouldn't compound at the same rate because the tax breaks aren't as good. First, she's putting aftertax dollars into her taxable account, so her initial investment is smaller--$5,063 versus the full $6,750 for our HSA investor. Even if she buys and holds a security that earns 4% and makes no dividend or capital gains distributions during her holding period, she's going to have to pay long-term capital gains taxes on her withdrawals of investment earnings--currently 15% for investors in the 25% tax bracket. In my simplified example, she'd have $261,148--more than $100,000 less than the HSA investor after 30 years.

Using our simple example, the HSA contributions even look more attractive than contributions to a 401(k). Contributions to a traditional 401(k), like an HSA, are pretax, so our investor puts $6,750 annually into her account. She earns a 4% return, just like the HSA contribution does, but all of her traditional 401(k) withdrawals will be taxed. Assuming she's in the 25% tax bracket in retirement, her $378,573 will shrivel to $283,930 when she pulls money out.

Costs Matter Before you run out and fund your HSA to the limit with an eye toward letting the money ride, it's worth noting that my example casts the HSA in the most flattering possible light. As noted above, HSAs can carry additional costs, which can erode their return advantage versus investing in a taxable account or even a 401(k) plan. In addition to expense ratios for investment funds, HSAs can levy fees for ongoing maintenance or to transfer money from the savings-account option into the investment platform.

But even if I scale down the HSA investor's return to account for those higher costs--taking the return from 4% to 3%, for example--the HSA investor's account still comes out ahead of the taxable investor's. Owing to the HSA's tax benefits, the HSA investor earning 3% would have $321,134 at the end of the 30-year period, versus $261,148 for our hypothetical investor in a taxable account.

It's also worth noting that investors whose employers have opted for a high-cost or otherwise-weak HSA have an escape hatch. A good strategy is to contribute to the company's HSA each year, thereby enjoying the convenience of having your contributions extracted on a pretax basis from your paycheck. You can then regularly roll over the HSA assets into the lower-cost plan of your choice, much as you would when rolling over one IRA to the next. In this respect, it's actually easier to circumvent a weak HSA than it is to get away from a weak 401(k). The Bogleheads site has a useful compendium of some of the large HSAs.

Other Considerations But even though HSAs' tax benefits can help compensate for their costs, most financial advisors still put HSAs behind tax-favored retirement plans like 401(k)s in the funding queue. As discussed in this article, HSA distributions have more strings attached than do withdrawals from IRAs or company retirement plans. For one thing, HSA owners will pay taxes and a penalty to withdraw assets for non-health-related expense prior to age 65, versus 59 1/2 for IRA withdrawals. (Roth IRA contributions can be withdrawn tax- and penalty-free.) Moreover, the penalty is higher for nonhealthcare withdrawals prior to age 65--20% versus 10% for IRA withdrawals prior to retirement. And while loans from 401(k)s are permissible (though not advisable in many instances), you cannot take a loan from an HSA.

Would-be HSA contributors should also consider their anticipated healthcare expenses in retirement before maxing out an HSA as an investment vehicle. Fidelity recently estimated that the typical couple will spend $260,000 on out-of-pocket healthcare expenses in retirement, a figure that doesn't include long-term-care costs. But individuals whose employers will pick up their in-retirement healthcare costs--while a shrinking share of the population--will likely spend less. It's not a disaster to overinvest in an HSA, in that in-retirement withdrawals for nonhealthcare expenses are treated just like 401(k) withdrawals are. But a 401(k) offers more flexiblity, as outlined above, and may also have lower overall costs than an HSA.