If you have a qualified High-Deductible Healthcare Plan (HDHP), Health Savings Accounts (HSAs) are wonderful tools to save for future medical costs.
With a HSA, your contributions are pre-tax (or tax deductible). Essentially, you won’t owe federal taxes on the income you contribute to the account. Further, you have the ability to invest your balance tax-deferred. This means your dividends and capital gains won’t be taxed as they grow with the market. The growth offsets the inflation in medical care over time. Finally, when you eventually use the appreciated balance for qualified medical expenses, you’ll incur NO TAXES – even on the market gains! However, there are some restrictions with your HSA. If you tap your account for non-qualifed expenses, you’ll incur taxes and a 10% penalty.
Even with these limitations, HSAs are a very popular means to save for future medical emergencies.
However, should you even invest your HSA funds? If so, should you invest all or just a portion of your HSA?
After all, investment gains aren’t guaranteed. While the market appreciates over the long-term, there’s always the chance of sudden declines that could put your money at risk in the short-term.
If you had a sudden medical emergency and needed to tap your HSA to pay your bills during a market correction, there’s a chance you could be underwater on your investments.
So, should you invest your HSA balance in the first place or leave it all in cash?
Before exploring your alternatives, let’s get a better understanding of the basics of the HDHP + HSA and how you can prepare for your future medical needs.
What exactly is a High-Deductible Healthcare Plan (HDHP)?
With a HDHP, you’ll bare the brunt of your medical costs until your deductible is met. Generally, these plans have much higher annual deductibles than traditional insurance plans.
However, the premiums you pay your insurance provider tend to be much lower each month. After all, you’ll be responsible for healthcare costs until you meet your deductible rather than just having a small copay.
In order to be a qualified plan, the annual deductible must be $1,400 for singles and $2,800 for families in 2020. Once you reach your deductible, insurance begins covering a percentage (for example, 80%) of your medical expenses.
HDHPs also have another appealing feature. Qualified HDHPs have a limit to the total medical costs you will face in a given year. In 2020, the total out-of-pocket maximums for singles cannot exceed $6,900. For families, maximum costs can’t exceed $13,800 according to Healthcare.gov.
This means your financial risk is capped at the out-of-pocket maximum. Your out-of-pocket max shields you from catastrophic financial burdens due to extended hospital stays, costly medication, or chronic conditions that can take a toll on your budget.
Who is a HDHP right for?
Generally speaking, HDHPs are great for those who do not need frequent medical attention or those who have chronic, expensive conditions.
If you don’t go to the doctor but a few times a year (other than routine physicals and other preventive care which are typically covered under the HDHPs), you’ll most likely save enough on your monthly premiums to offset a few visits to the doctor.
On the other hand, those who have chronic, expensive conditions may also benefit from HDHPs. Because HDHPs have a cap on medical expenses, those who are undergoing expensive treatments or have chronic conditions could hit their max relatively early in the year. Then, insurance would cover 100% beyond their maximum out-of-pocket expense.
Who may need to consider alternative plans with a lower deductibles?
HDHPs aren’t right for everyone.
Like any other insurance, you will need to compare the savings on your monthly premiums with the additional exposure you face covering more of your medical bill. Sometimes, the monthly premiums may not be low enough to justify the additional risk.
For those who don’t have savings to cover the higher out-of-pocket expenses, it may be better to stick with a lower deductible plan until you’re able to accumulate some savings just in case you have an unexpected, costly medical event in Year 1.
However, over the long run, the premium savings often justify the periodically higher bills from having a high-deductible plan. Coupled with investing in a HSA, you have the potential to self-insure and build wealth rather than being a profit center for the health insurance industry.
Should you invest your HSA balance?
Now that we have the basics of a HDHP + HSA, let’s dive into whether growing your money in the market makes sense.
Deciding whether to invest your balance is a good choice largely depends on 5 key conditions:
- Overall financial position
- Known medical expenses or procedures in the near future
- Whether you need to tap your HSA balance in the near-term
- Market performance
- Your ability to stick to your long-term investing plan
After you analyze your insurance and investment options, you may have a better understanding of the risk vs. reward in having a HDHP + HSA. However, if you’re still unsure, talk to a fee-only financial advisor. This is a prudent step to take as you navigate the complexities of insurance and investing.
1. Overall financial position
According to CNBC, early 66% of bankruptcies in America are due to medical costs.
In order to avoid becoming a casualty of the exorbitant cost of medical care, you should ensure you and your family have the proper level of coverage based on your particular needs.
Generally speaking, the more wealth you have accumulated and the higher your monthly margin, the more risk you can assume. On average, pretty much all insurance is profitable (otherwise, the insurance company would go bankrupt). Therefore, the insurance companies know what to charge you and other people like you to cover their cost to insure and earn a profit.
Your overall financial situation plays a key role in determining the risk you can absorb without worrying about going broke from a medical emergency.
Scenario 1: Those with lower income and less in savings
If you’re just starting out in an entry-level job and have other debts, you may not have the financial bandwidth to take on the risk of a $1,400+ deductible in the first place (much less, investing your HSA balance).
In the event of a medical emergency in the first few years of coverage, you could be out $1,000+ before you’ve taken advantage and saved your HDHP’s lower premiums into your HSA. This could certainly leave you exposed and in debt.
Further, if you are in a low tax bracket, the tax deduction would be less beneficial. For 44% of Americans who don’t owe federal taxes, the tax destructibility of HSA contributions is a moot point.
For individuals in this scenario, a HDHP + HSA may not make as much economic sense. If you do choose the high-deductible route, you could be exposed the first few years as you begin padding your HSA with your lower premiums and any extra cash to pay for future medical costs.
If you do choose the HDHP + HSA route, keep an ample amount of cash to cover your deductible (and maybe even your annual out-of-pocket max).
For those who cannot save much every month for future medical costs, 2 or 3 years of savings could be wiped-out in a single, catastrophic event. For this reason, ensure you have contributions automatically deducted from your pay and into your HSA balance.
Alternatively, you could choose a lower deductible plan until you have the financial wherewithal and discipline to assume the higher out-of-pocket costs.
As you earn more, create margin in your monthly budget, and build more liquid savings, you can always change to a HDHP in the next open enrollment cycle.
When you’ve built enough cushion, you can always start investing then.
Scenario 2: Those with more financial bandwidth or savings
By contrast, if you’re earning enough each month or have savings to cover your medical care up to the deductible, you may be better positioned to invest all or a portion of your HSA balance.
Whether you’re single or covered under a family plan, ensure you have the income or savings to withstand at least up to the plan deductible. With any extra above the deductible, you can consider investing and growing this portion.
Choosing to invest all or a portion of your HSA balance largely depends on how meeting your deductible will impact your quality of life and financial well-being.
If you have the monthly margin to cover periodic doctors’ visits throughout the year ($100-$200/each) without needing to tap your HSA funds, you can probably invest a greater percentage of your balance.
Similarly, you may experience a medical episode or two that causes you to meet your deductible or start inching towards your plan max. If this represents a small percentage of your overall net worth, you can probably pay your bills out of monthly cash flow.
Also, if you have a properly funded emergency fund of 3-6 months of expenses, you could instead pull from your liquid cash savings while keeping your HSA invested. Next month, you can begin rebuilding your cash pile. Worst case, you can always sell a portion of your investments. Then, reimburse yourself for the qualified medical expenses.
Ultimately, having other sources of funds (monthly surplus or liquid savings) means you could keep more of your HSA invested. Simply reimburse yourself in the future when you truly need the money. (Just be sure to keep your receipts for reimbursement!)
2. Known upcoming medical expenses
If you have any known medical procedures on the horizon, you should factor this cost into how much of your HSA balance to invest.
For instance, you may be expecting a child in the near future. As the cost of having a child averages $3,500, you may be better off keeping at least known future expenses in cash.
Even if you plan to pay for these costs with other savings, having a larger cash balance in your HSA can ease your worry during this stressful time. Once the family comes home healthy and happy, you can always reinvest your cash.
Some people have chronic conditions where they know they’ll reach their deductible in a given year.
For these people, it may be tough accumulating a large amount of savings in their HSA to invest. However, your HSA can still be a powerful tool that helps offset the cost of your medical care.
With a HSA, you can run your medical expenses through your HSA pre-tax. This effectively reduces your total out-of-pocket cost by the tax savings.
Let’s look at an example for context
For instance, let’s say your effective tax rate is 25% and you incur a $1,000 medical bill. Before paying the bill, contribute $1,000 to your HSA. Most HSA custodians (i.e. Fidelity and HSA Bank) provide debit cards that are linked to your account.
Then, simply pay for your $1,000 medical expense from your HSA. When you file your taxes, you’ll be allowed to deduct your contribution (i.e. the $1,000). Since the effective tax rate is 25% in this example, this person would pay $250 LESS in taxes. Therefore, their total out-of-pocket cost was only $750.
For those with chronic illnesses, the HSA can be used as a channel to reduce their total cost. However, remember that contributions to HSAs are limited by the IRS.
3. Your near-term needs for the money in your HSA
Similarly, your near-term (< 5 years) need largely dictates if and how much you can invest in your HSA.
If you don’t have any other savings and have a big-ticket medical expense around the corner, you’re probably better off keep at least this much in cash. By contrast, if you have plenty in savings, you probably have the ability to invest your balance without needing to sell your investments to cover a medical bill.
If you don’t have any known procedures, consider the portion of your HSA you won’t need for 5+ years.
Investing should be for the long-term – EVEN in your HSA
On average, the stock market has returned 10% annually.
However, a 10% annual return is simply the average.
In any given year, the stock market can rocket higher or plummet lower. During certain periods, the market enters a correction or “bear market.” In these down years, stocks can decline more than 20%. Typically, bear markets have occur every six years.
However, in other years, investors experience bull markets as stocks bound higher. Over time, these bull markets have more than made up the losses of bear markets. Therefore, the stock market has generally risen over time.
Over longer periods of time, your investment gains can help offset medical inflation which has averaged 5.3%. With each passing year, the stock market returns give you more “buying power” in your HSA.
However, predicting the future of the stock market can be a futile exercise.
Therefore, as with any investing, keep a long-term perspective and ONLY invest money you won’t need for 5+ years. Having a long-term mindset mitigates the risk of losses in your HSA.
4. Stock market performance
As mentioned, predicting the stock market can be virtually impossible.
However, future stock market returns is a large factor in determining how much of your HSA balance you should invest. Obviously, if you had a crystal ball and could predict market returns, you would sell before a downturn and buy at the very lows. Clearly, nobody has this magic power yet.
Therefore, we must do the best we can to optimize our HSA portfolio based on our overall financial situation.
Taking a balanced approach
While your HSA is a wonderful wealth-building tool because of it’s triple tax-advantaged nature, the point of insurance is RISK MITIGATION.
Your HSA portfolio mix should be a reflection of your overall risk tolerance, future medical needs, and market expectations.
My HSA investing situation
Personally, I take a fairly balanced approach in my HSA investing. I am young, healthy (knock on wood), and have a healthy lifestyle. Therefore, I rarely need medical attention outside of routine physicals and periodic allergy issues.
Further, I have a stable financial and employment situation as a CPA. I have made fairly good financial choices that have allowed me to build a comfortable nest egg for my age. I live well below my means and am able to save 30%-40% of my monthly income. Plus, I have around 6 months of emergency savings OUTSIDE of my HSA.
All of these factors allow me to take a little more risk in my HSA investing. However, I still keep around 20%of my HSA in cash as cushion. The remaining balance is invested in index funds that mirror the NASDAQ-100 and S&P 500. Each month, I dollar-cost-average my monthly contribution. When the market declines 10%+, I either up my contributions or use some of my available cash to take advantage of downturns.
Certainly, your situation differs from mine. Therefore, my strategy may not be best for your situation. Consider speaking with a financial advisor or your broker for more technical guidance.
The market is out of your control
Controlling the stock market is obviously impossible.
However, you can minimize market risk and ensure the principle balance of your portfolio grows over time to provide the coverage you need for future medical costs.
More than likely, a balanced approach represents a prudent tactic to take. Having some liquidity to meet your deductible keeps you from needing to sell your investments during market downturns. Further, cash allows you take advantage of market dips and sleep well at night knowing you have plenty of cash to cover whatever comes your way.
5. Your long-term investing approach
As discussed in the previous point, your HSA portfolio should be treated just like any other long-term investment.
However, investing in a HSA can go far beyond the face value of saving for upcoming medical costs. While the HSA is most effective in paying for medical expenses (i.e. you receive the tax-free distributions), your HSA has some flexibility that goes beyond healthcare.
HSAs can also be used as a de facto retirement accounts
Remember that 10% penalty for taking distributions from your HSA for non-qualifed expenses? After age 65, this 10% penalty is no longer applied for non-qualified distributions.
By default, your HSA acts just like a Traditional IRA. You received the tax deduction when you made the contributions and the tax deferral on the growth. As distributions are made, you only owe taxes on the gains.
Therefore, you never need to worry about over-funding your HSA.
More than likely, you’ll have more medical expenses as you age. Plus, you can use your HSA to cover certain premium costs after age 65. For these qualified expenses, you’ll still receive the the tax-free distributions from your HSA. In result, you’ll need to pull less money from other accounts or line items in your budget.
Even if you don’t need all of you HSA for medical, you will be able to access your account to supplement your lifestyle in retirement. You’ll simply owe taxes (but no penalty) on the gains.
HSAs for Early Retirement
These accounts are highly recommended for those in the F.I.R.E. Community. If you’re new to FIRE, the acronym stands for “Financially Independent / Retire Early.”
With their astronomical savings rates (50%+), those who subscribe to the FIRE lifestyle are often able to retire in 10-15 years. Many are able to quit their traditional jobs in their early 30s.
How do they do it? Cutting back on lifestyle expenses, starting side-hustles to earn more, and investing in low-cost index funds or real estate until they reach 25x their annual expenses through passive investments.
If you’re interested in learning more about this alternative lifestyle, read more about FIRE here.
Using the a HDHP + HSA for FIRE
One way many in the FIRE Community cuts back on expenses while simultaneously saving is through HDHP + HSAs.
During their traditional working years, many FIRE followers pile cash into investments in the HSA. This lowers their adjusted gross income and allows them to defer taxes on the investments.
As they have routine medical costs, instead of withdrawing from the portfolio, they simply keep the money invested and save the receipt for future reimbursement. After all, there’s no time limit on reimbursement for medical costs.
With this strategy, they’re simply delaying reimbursement in their working years for their early retirement years. When they’re no longer earning an income, their HSA can be a source of tax-free distributions thanks to the reimbursement. This allows the money to stay invested for 10+ years and compound over time.
Even if you don’t want to implement the FIRE lifestyle, you can still use this approach. By saving medical receipts and reimbursements for later, you can allow you invested principle to continue growing tax-advantaged. In the future, you can use the accumulation of reimbursements to pay for those big-ticket expenses.
HDHP + HSA Summary: So how much will you invest?
Deciding whether a HDHP + HSA is right for your situation may not be the easiest decision.
Hopefully, after reading this article you have a better understanding of the basics of high-deductible plans and the flexibility of investing in a HSA.
However, even if you determined a HDHP + HSA is right for you, deciding how much of your HSA balance to invest can also be challenging.
Hopefully, these 5 key considerations provide some guidance as you navigate the nuances of HSA investing.
As always, before any investing or insurance changes, you should seek the help of a professional that can properly assess your personal situation.