Morningstar Magazine - October/November 2017 - 36

Spotlight: HSAs

individuals' savings tool kits, especially for
those who can afford to pay their actual healthcare
expenses out of pocket while leaving their
health savings account assets in place to grow.
To date, just a fraction of the total assets
in HSAs-$5.5 billion in 2016-is stashed in
long-term investment accounts; the bulk
of HSA assets are parked in savings and checking
accounts so that investors can use the
funds for out-of-pocket healthcare costs as they
incur them.
But because the accounts offer three tax benefits-
tax-free contributions, tax-free compounding,
and tax-free withdrawals for qualified healthcare expenses-they're particularly advantageous
for investors who can use their HSAs as
long-term investment vehicles. If investors are
able to pay out of pocket for healthcare
costs and allow their HSA accounts to grow, the
HSA assets can better harness the power of
compounding, and the tax benefits are also more
valuable when stretched over a longer period
of time.
Investors need to do their due diligence
before they employ an HSA as a long-term
investment vehicle, though. As you'll
read in the following article, much of what HSA
plans offer investors are high costs and
poor investment options-although a few
plans do earn positive assessments for their
investment side. The article is based on
a first-of-its-kind study in which we aim to shine
the light on the merits of HSAs as both
pay-as-you-go savings accounts and long-term
investment vehicles.
In addition to gauging HSA quality, long-term
investors need to consider the logistics
of managing their HSAs, especially if their plan is
to carry the HSA assets into retirement. How
should HSA assets be allocated during retirement?
Where in the retirement-funding queue do
these accounts belong? And importantly, what
happens to an HSA if the accountholder were to
pass away before spending all the money?
These are all valuable considerations for investors
who are using HSAs as part of their longterm retirement program, not as vehicles to spend
as they go.

Morningstar October/November 2017

Let It Grow

The starting point for investors thinking about
how to invest their HSA is to consider when they
would actually spend those monies. As noted,
HSAs enjoy triple tax-advantaged status,
and the benefits of that tax-free compounding
increase the longer the money is invested.
To use a simple example, let's say an investor
contributed $6,000 to her HSA and earned
a 5% annualized return over the ensuing 10 years.
She'd have nearly $10,000 at the end of the 10-year
period, and she wouldn't owe any taxes along the
way-not on contributions, growth,
or withdrawal, provided she uses the funds for
qualified healthcare expenses.
Meanwhile, an investor who used aftertax dollars
to contribute to a taxable brokerage account
would steer $4,500 into the account-the $6,000,
less taxes, assuming she's in the 25% income-tax
bracket. Assuming a 5% annualized return
on her money, she'd have $7,412 in the account
10 years later. She'd then take a tax haircut on the
appreciation when she pulls the money out;
assuming a 15% capital gains rate, her take-home
return would be less than $7,000.
Asset Allocation

If an investor is earmarking HSA assets for
retirement, those assets can be managed in line
with other retirement assets; the longer the
time horizon until spending, the more aggressively
positioned those assets should be. But as
retirement draws near, it makes sense to think
about a liquidation strategy for the accounts,
based on anticipated healthcare spending needs.

the assets in the account. The bucket approach
ports over nicely to an HSA spending plan. Similar
to my bucket approach to total retirement
portfolios, a retiree could hold one to two years'
worth of health expenses in the savingsaccount option of the HSA, another seven or so
years' worth in bonds, and the remainder in stocks.
Where in the Retirement Distribution Queue?

In addition, retirees will also want to consider how
their HSAs fit in with other assets in the
distribution queue. Assuming a retiree has
multiple accounts to choose from, the HSA should
logically come after withdrawals from taxable
accounts and traditional IRAs and 401(k)s. That's
because HSAs enjoy tax-free compounding
and withdrawals are tax-free for qualified
healthcare expenses, so it's valuable to hang on to
those benefits for as long as possible. Taxable
account withdrawals, by contrast, will at a
minimum be subject to capital gains taxes on
appreciation; they may also incur taxes if they hold
investments that kick off taxable income
or capital gains during the investor's holding
period. Withdrawals from tax-deferred accounts,
meanwhile, are taxed at investor's ordinary
income tax rates; these accounts are also subject
to required minimum distributions, whereas
HSAs are not.

To project spending, it's helpful to review which
expenses qualify for tax-free withdrawals.
Importantly, premiums for Medicare supplemental
policies don't qualify as tax-free withdrawals,
though Medicare insurance premiums (for Parts B,
C, and D), long-term care insurance premiums
(up to the IRS limits), and out-of-pocket
pharmaceutical costs, among others, would
all be eligible. (IRS Publication 969 details
which healthcare expenditures qualify for taxfree withdrawals.)

But how about withdrawals from HSAs versus
Roth IRAs? Withdrawals from HSAs are taxfree, just like Roth IRAs; nor do RMDs apply to
either account type. But inherited HSAs don't have
the same tax benefits that Roth IRAs do. If
a spouse is the beneficiary of an HSA, he or she
can maintain the account as an HSA and continue
to take advantage of those generous tax
benefits. On the other hand, if someone other than
the spouse is the beneficiary of the HSA, the
HSA and its attendant tax benefits cease to exist
upon the death of the original HSA owner.
That means the inherited amount is fully taxable
to the beneficiary. Given those drawbacks, that
suggests that HSA owners with a nonspouse
beneficiary (or a spouse beneficiary with a limited
expected life span) prioritize HSA withdrawals
well ahead of Roth IRA withdrawals.

Armed with an estimate of annual healthcare
spending needs, a retiree can then position

Those rules also suggest that HSA investors
consider the beneficiaries of their accounts. While

Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2017