The Power of Health Savings Accounts (HSAs) in Your Financial Toolkit

Health Savings Accounts (HSAs) can be a powerful addition to your financial toolkit, particularly for individuals who have the ability to pay their healthcare expenses out of pocket while allowing their HSA funds to grow over time. HSAs are often overlooked, but they offer unique advantages that make them an attractive option for long-term savings and investment. By leaving HSA funds untouched and allowing them to compound, you can maximize the tax benefits and growth potential of these accounts. However, before using an HSA as a long-term investment vehicle, it’s important to do your due diligence and understand how to make the most of this tool.

One of the most significant benefits of an HSA is its triple tax-advantaged status: contributions are tax-deductible, the money grows tax-free, and withdrawals for qualified medical expenses are also tax-free. The longer you allow your HSA funds to grow, the more you can harness the power of compounding. For example, if you contribute $6,000 to an HSA and earn a 5% annual return over 10 years, your account could grow to nearly $10,000—without any taxes owed along the way. This is far more favorable than using a taxable brokerage account, where taxes would reduce both your contributions and your returns.

Let Your HSA Money Grow

The key to maximizing the value of your HSA is to consider when you’ll actually need to use the money. If you can afford to pay out-of-pocket for healthcare expenses rather than tapping into your HSA, you can let your account grow over time. The longer your money stays invested, the greater the benefits of tax-free compounding. For instance, an investor who contributes $6,000 to an HSA and earns a 5% annual return over 10 years could end up with nearly $10,000. In contrast, if the same investor used after-tax dollars in a taxable brokerage account, they would only have about $7,000 after taxes and fees.

HSAs also offer flexibility in how you manage your assets. Like retirement accounts, HSA funds can be invested in a variety of assets, such as stocks, bonds, or mutual funds. The longer your time horizon, the more aggressively you can position your portfolio. However, as you approach retirement, it’s important to think about a liquidation strategy based on your anticipated healthcare spending needs. This involves estimating which expenses will qualify for tax-free withdrawals. For example, Medicare insurance premiums (Parts B, C, and D), long-term-care insurance premiums, and out-of-pocket pharmaceutical costs are all eligible expenses.

How to Think About HSA Asset Allocation

When managing HSA assets, it’s helpful to align your strategy with your other retirement accounts. If you have a long time horizon until you’ll need the funds, you can afford to take on more risk and position your portfolio more aggressively. However, as retirement approaches, it’s wise to shift toward a more conservative allocation to ensure that your HSA funds are available when needed. This involves estimating your annual healthcare spending and positioning your assets accordingly.

For example, if you anticipate high out-of-pocket medical expenses in retirement, you may want to allocate a portion of your HSA to more liquid assets, such as cash or money market funds, to cover those costs. On the other hand, if you expect lower healthcare expenses, you may be able to afford a more aggressive investment strategy, allowing your HSA to continue growing over time.

Where Does an HSA Fall in the Retirement Distribution Queue?

When planning for retirement, it’s important to consider how your HSA fits into your overall distribution strategy. HSAs are unique in that they offer tax-free compounding and withdrawals, making them a valuable resource to preserve for as long as possible. As a result, they should generally come later in the distribution queue, after withdrawals from taxable accounts and traditional IRAs or 401(k)s.

For example, you might prioritize taking withdrawals from taxable accounts first, as these are subject to income tax and capital gains tax. Next, you could withdraw from traditional IRAs or 401(k)s, which are also subject to income tax. Only after exhausting these sources should you consider withdrawals from your HSA, as these are tax-free for qualified medical expenses.

That said, HSAs and Roth IRAs share some similarities, as both offer tax-free growth and withdrawals. However, there are key differences. For instance, HSAs do not have required minimum distributions (RMDs), and withdrawals for qualified medical expenses are tax-free at any age. Roth IRAs also do not have RMDs, but withdrawals are only tax-free if they are qualified (e.g., for a first-time home purchase or after age 59½).

Beneficiary Considerations for Your HSA

Another important aspect of HSA planning is considering who you name as the beneficiary of your account. HSAs can be passed on to your heirs, but the tax implications vary depending on who inherits the account. If your spouse is the beneficiary, they can treat the HSA as their own, retaining the tax-free benefits. However, if a non-spouse inherits the HSA, such as a child or other relative, the account loses its tax-free status. In this case, the beneficiary will owe income tax on the fair market value of the HSA assets at the time of inheritance.

Given these rules, it’s worth considering alternative strategies. For example, if you have a surviving spouse, they may choose to spend down the HSA or name a charity as the next beneficiary. Charities do not owe taxes on inherited HSA funds, making this a tax-efficient way to leave a legacy. On the other hand, if you anticipate that your heirs will need access to the funds, it may be worth prioritizing withdrawals from the HSA during your lifetime to minimize the tax burden.

Conclusion: Maximizing the Value of Your HSA

In conclusion, Health Savings Accounts offer a unique combination of tax benefits and flexibility that make them a valuable tool for both healthcare spending and long-term savings. By leaving your HSA funds untouched and allowing them to grow over time, you can maximize the power of compounding and enjoy tax-free withdrawals for qualified medical expenses in retirement. As with any financial tool, it’s important to carefully consider your investment strategy, distribution plan, and beneficiary designations to make the most of your HSA.

With proper planning, an HSA can play a critical role in your overall financial strategy, helping you prepare for healthcare expenses while also building a nest egg for the future.

This article was provided by Morningstar, a leading authority on personal finance and retirement planning. For more insights and resources, visit Morningstar’s Personal Finance page. Christine Benz, director of personal finance and retirement planning, and Margaret Giles, senior editor of content development, contributed to this article.