You're Using Your HSA All Wrong

Editor's note: We have published new research and enhanced our methodology. Read our evaluation of the best HSA providers of 2022.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Morningstar recently updated its annual rankings of the largest health savings accounts. Here with me today to discuss why investors should think about using HSAs as investment accounts is Leo Acheson. Leo is a director in Morningstar's Manager Research group and an author of our latest research.

Hi, Leo. Thanks for joining me today.

Leo Acheson: Of course. Thanks for having me.

Dziubinski: Let's take a step back and briefly start with talking about what HSAs are and who has access to one.

Acheson: HSAs are tax-advantaged vehicles to save for qualified medical expenses. They are really only available to people that are in high-deductible health plans, so not those that are in low-deductible health plans. But if you are in a high-deductible plan, it's the most efficient way that you can save for your medical costs.

Dziubinski: Now, we often hear that HSAs have these unrivaled tax advantages. Can you unpack that a little bit for us?

Acheson: Absolutely. Some refer to it as a triple tax advantage. It's actually a quadruple tax advantage, in a sense. So, money goes in tax-free, money grows tax-free, and then you can withdraw it tax-free as long as it's spent on qualified medical expenses. But in addition to all of that, you skip out on payroll taxes. These vehicles are different from 401(k)s, IRAs, 529s, all of those tax money either on the way in or on the way out, and they also do not skip out on payroll taxes. So, HSAs have this quadruple tax advantage of goes in free, grows free, withdraws free, and skips out on payroll taxes.

Dziubinski: Wow. HSAs can be used a couple of different ways. One is sort of that spend-as-you-go approach. You put your money in your HSA and then you use that money over the course of the coming year to cover your medical expenses. But another way to use an HSA is to use it as an investment vehicle. And you've done some research into this. How do you see that that breaks down, people that use it to spend versus people that use it as an investment vehicle?

Acheson: The vast majority of people are using it to spend to cover their current medical costs. From our research we have found that roughly about 5% or 6% of individuals actually are investing their assets and growing them, which is really the way that you maximize the tax benefits that are available in HSAs. You've seen that tick up. A few years ago, it was more like 2% or 3% of account holders were investing, and now it's up to 5%-6%. So, as you continue to see that grow then people would obviously benefit from the tax advantages that HSAs offer.

Dziubinski: And is that the primary reason, Leo, that people should be considering using HSAs as investment vehicles for that tax benefit?

Acheson: Well, they are useful for both. I mean, a lot of people don't have the means to use their HSA and invest that money. They actually need to use it to cover their current medical costs, and it's still a great vehicle for that because you aren't paying taxes. You aren't paying your income taxes or your payroll taxes. So, it's an immediate savings if you need to use it to cover current medical costs. But if you happen to have the financial means where you can actually take your HSA contributions and invest it and then pay for your medical costs out of pocket so that your HSA investments are able to grow tax-free, which really makes the tax benefits exponentially better, then yes, that is more optimal. So, they are great for both, but they are better meaningfully for investing.

Dziubinski: And at the end of the time you still need to be using those for medical expenses?

Acheson: Correct, yes. They do need to be used on qualified medical expenses. Fidelity has come out with a lot of estimates for how much couples will spend on healthcare in retirement. I think the most recent estimate was around $280,000 in retirement total between a couple. That's a significant amount, obviously, and that also doesn't include long-term care, which HSAs are also eligible to pay for. So, it would be even more than that. So, yes, they would have to be spent on qualified medical expenses. However, if you happen to be very fortunate and healthy in your retirement and you want to spend the money on something else, then worst case, it's treated like a 401(k), where your money after the age of 65 if you withdraw it, then it's taxed on the way out. So, best case, you're able to take full advantage of the tax benefits of HSAs. Worst case, it's treated like a 401(k).

Dziubinski: And let's talk a little bit broadly about the HSA industry. Let's say, more people did begin to use their HSA as an investment vehicle versus the spend-as-you-go approach. What would that mean for the complexion of the industry? What could that mean for fees and what we pay for HSAs?

Acheson: It's very interesting. As I mentioned before, about 6% of account holders are using their HSAs as investment vehicles. However, that 6% makes up over 25%--I think it was around 27% or so--of total HSA assets. Just think how much the HSA industry could grow if more and more people were investing it. And if you saw more and more people investing, you would see asset bases grow, which should lead to economies of scale, and I would expect fee reductions.

Dziubinski: And every investor likes a fee reduction, so that would be great news.

Acheson: Of course, of course.

Dziubinski: Leo, thank you so much for your time today. We appreciate it.

Acheson: Absolutely. Thanks again for having me.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.