[Editor’s Note: This article has been updated to clarify the source of HSA asset data in Morningstar’s report, which is Minnesota-based HSA provider and research firm Devenir. We regret the error.]
Health care is among the biggest expenses that clients will face in retirement, and the wildly disparate estimates make it hard to plan for. Fidelity estimates that a couple who retires today would need $285,000 to cover medical expenses. The Employee Benefit Research Institute (EBRI) projected that a couple with expensive medications may need nearly $400,000.
[Related: HSAs Can Be Used for COVID-19 Testing and Treatment: IRS]
HealthView Services, which publishes an annual report projecting health care costs in retirement, estimated in its 2019 report that a healthy 65-year-old couple who lives to their late 80s could spend more than $606,000 on their combined health care throughout their retirement.
Health savings accounts are a valuable tool for clients trying to plan for these kinds of costs. A client’s million-dollar 401(k) balance will look a lot bigger if half of it isn’t going to be spent on health care.
Since the HSA market was created in 2004 with the passing of the Medicare Prescription Drug, Improvement and Modernization Act, the number of HSAs reached an estimated 25 million in 2018, according to EBRI. Most of them—71%—have only been opened since 2015.
HSAs can be used as a checking account to cover current medical costs, or an investment account to save for future costs. Morningstar’s “2019 HSA Landscape Report,” citing data from Devenir’s 2019 Midyear HSA Survey, noted that total HSA assets topped $60 billion as of mid-2019. Although the vast majority of those assets (nearly $50 billion) are in checking accounts, invested assets are growing at a faster rate, the report found.
Leo Acheson, director of multiasset and alternative assets for Morningstar, noted that it’s not clear if that’s due to market appreciation or increased adoption.
The industry is taking steps to make it easier for clients to invest in HSAs. Over the past three years, Acheson has seen providers trim the fat from their investment menus.
“When we initially began evaluating these HSA providers in 2017, some of the providers offered hundreds of investment options in their investment menu, which in our view is overkill. It can lead to decision paralysis when you’re faced with that many choices,” he said. The 2019 report found the largest menu had been streamlined to a much less intimidating 33 investment options.
‘401(k) on Steroids’
Most advisors know HSAs are “triple tax advantaged.” Investors can fund the accounts with pretax dollars, interest earned in the account isn’t taxed and distributions aren’t taxed when they’re used on qualified medical expenses.
Matt Clarkin, president and cofounder of consultant firm Access Point HSA, notes that after a certain age, the 20% penalty for using HSA funds on nonqualified expenses goes away.
“At age 65, that HSA is a 401(k) on steroids. If I use it for a qualified medical expense, it’s tax free. If I use it for something other than that, I’m just paying ordinary tax on it.”
HSAs still turbocharge 401(k) savings for clients under age 65.
[Related: HSA Balances Growing Despite Obstacles]
“On the essentials and the lifestyle, you’ve got the 401(k) doing a great job, but it can’t do as good a job on the medical as the HSA can,” Clarkin said. Medicare Parts B and D are means-tested, he pointed out, so “if I’m only using my 401(k) to pay for my expenses in retirement, I may actually end up spending more for Medicare Part B and D because it’s means-tested based on my modified adjusted gross income. As opposed to if I’m using my HSA for that third leg of the stool, I avoid the possibility of having to pay more for Medicare in the first place, never mind the fact that I’m able to prepare for it on a tax-free basis.”
High Deductibles Set High Hurdles
As many advisors also know, to begin saving or investing in an HSA, clients must be covered by a high-deductible health plan and can’t be on Medicare. However, that can present a challenge to investors who are afraid of a high deductible.
“When they sit down and try to decide [between] a traditional plan or going with the high-deductible health plan, … they never consider what that HSA could possibly do for them. So, they missed a real big part of the calculus to make that decision in the first place,” Clarkin said. Advisors can provide a real service to their clients by helping them compare the relative savings of their health plan options, including coinsurance and copays after they meet their deductible.
“When I get past the deductible and I look at the difference in my premiums between the high-deductible plan and the PPO, there’s 100% chance that whatever your savings is on that premium, you’ll realize it,” Clarkin said. “You have to; it comes out of your pocket.”
There isn’t a 100% chance that an investor will have to pay their full deductible, he pointed out.
“One size never fits all, but there are a lot of folks who are probably on the PPO based just on being spooked by the deductible. [They’re] not thinking about the idea that you may not pay that deductible, the entire thing, and you are going to see the savings on your premium and you’ve got this HSA available to you, which is a super powerful tool in the long term help you pay your Medicare expenses and health care expenses in retirement.”
‘Don’t Leave Money on the Table’
Annual contribution limits for HSAs in 2020 increased to $3,550 for individual accounts, and $7,100 for family accounts. Catch-up contributions were unchanged at $1,000 for people 55 or older.
The 2020 contribution limit for 401(k)s was increased to $19,500, while the catchup contribution for participants 50 and older increased to $6,500.
Does it make sense then to max out savings in an HSA before contributing to a 401(k)? It’s all in the details, according to Morningstar’s Acheson.
“If you’re saving through your company, it depends what your company matches in the 401(k) versus any contribution they might make to your HSA. So while the HSA would have greater tax benefits, the contribution or the match might be higher for your 401(k) than your HSA,” he said. Clarkin agreed. “Don’t leave money on the table,” he said. “Don’t contribute to your HSA until you’ve taken full advantage of that match, but at that point, it’s very hard to argue not to max out your HSA and then go back to your 401(k).”
Fee Fright
A potential obstacle for advisors incorporating HSAs into their clients’ retirement plans is fees. Acheson warned that determining the fees charged by an HSA provider can be tricky. Fees can be numerous, and there aren’t consistent disclosure requirements.
“Be careful of the fees that are present in HSAs. There are a number of different fees to watch out for, especially if you’re investing,” he said. “There are underlying fund fees, of course, and then most of the providers charge an investment fee if you want to invest. On top of that, there’s a range of additional fees that can be charged for things like excess contributions, paper statements, things like that.”
Morningstar’s HSA landscape report found that although fees are coming down, they’re still high and vary drastically. The 10 providers examined in the report charge between 0.02% and 0.69% annually for the cheapest passive 60/40 portfolio.
Some providers will waive account maintenance fees at a certain threshold, Acheson said, but others don’t and some (like Fidelity, Lively and the HSA Authority) don’t charge them at all.
“Comparing one HSA versus another from a fee standpoint is pretty challenging. It can be really hard to get transparency on these HSAs just by looking on the website,” he said.
HSAs and Long-Term Care
Although insurance premiums aren’t typically considered qualified health expenses for a health savings account, the Internal Revenue Service does allow HSA owners to use funds on long-term care insurance premiums up to a certain amount. The amount depends on the owner’s age, ranging from $430 for someone 40 or younger to $5,430 for someone 71 or older.
A white paper by Nationwide notes that while long-term care policy premiums meet the IRS’s requirements for a qualified medical expense, an LTC rider on a life insurance policy does not. That’s partly due to a rule in the Pension Protection Act of 2006, according to Nationwide, “which states that if the cost of an LTC rider on a life insurance policy is paid for by a deduction from the cash surrender value, then it will not be considered a qualified medical expense.”
There are other restrictions for owners who want to use HSA funds to pay for LTC premiums: They may not take a Code Section 213 medical deduction to pay for the same premiums.
The IRS considers long-term care services qualified if they’re required by a chronically ill person, and are part of a care plan set out by a licensed health care professional.