Medical costs are rising. Stocks are slumping. How to get the most bang out of this tax-favored account

Published Fri, Sep 30 202212:18 PM EDT

Rising medical costs and the recent stock-and-bond market volatility may have Americans considering investing in health savings accounts, especially with open enrollment season getting underway. HSAs, in which people with high-deductible insurance plans save for qualified medical expenses, have one thing that no other investment has: a triple tax benefit. Contributions are tax deductible; investment growth, interest and dividends are tax-exempt and there are no levies on any withdrawals for qualified medical expenses. Yet to get the most out of that tax savings, you'll have to put some of the money into longer-term investments, so it can grow tax free and ideally be used in retirement. The money in your account rolls over year after year, unlike flexible-spending accounts. You can also get reimbursed years later for qualified expenses incurred now, as long as you hang on to the receipts. "It's another retirement bucket," said certified financial planner Candace Lee, vice president at Glassman Wealth Services in Vienna, Virginia. However, she suggests first maxing out your retirement accounts, such as a 401(k), before maxing out your HSA. You can contribute up to $3,650 for individual coverage and up to $7,300 for family coverage in a 2022 HSA. Next year, that maximum increases to $3,850 in an individual health insurance plan and to $7,750 with a family plan. It's helpful to have some money saved for future medical expenses, since they are likely to be higher when you are older. A 65-year-couple retiring this year can expect to shell out an average $135,000 in medical and health-care expenses in their retirement, not including long-term care, according to an estimate by Fidelity Investments . That is 5% higher than last year's estimate. Yet it is not just senior citizens affected by high medical bills. Health-care spending overall has also grown, making up 20% of total U.S. gross domestic product in 2020, compared to just 5% in 1960. That's why it's important to also keep money available in an HSA to pay any out-of-pocket costs that you can't cover with your income. A good rule of thumb is to have the amount of your deductible set aside in cash or fixed income, said CFP Carolyn McClanahan, founder and director of financial planning at Life Planning Partners in Jacksonville, Florida. The average general annual deductible for an HSA-qualified high-deductible health plan in 2021 was $2,454 for single coverage, according to the Kaiser Family Foundation . "You have to make sure that you have the ability to absorb that [deductible] should some catastrophic event happen to you," she said. Most Americans avoid putting any stocks or bonds in their HSAs, which means they are potentially losing out on tax-advantaged long-term investment growth. Just 9% of HSA accounts had made investment elections across providers, according to Morningstar's 2022 Health Savings Account Landscape report . However, investing account assets accounted for over 36% of total assets, the report found. Choosing an HSA You can participate in your employer's HSA, if one is offered. Some companies also contribute towards your savings. Covered workers enrolled in HSA-qualified, high-deductible health-care plans, on average, receive an annual employer contribution to their HSA of $575 for single coverage and $987 for family coverage, according to the Kaiser Family Foundation. You can also open an individual account through a provider. Morningstar ranked 10 of the top HSA providers on two uses: as a spending account to cover current costs and as an investment account, meant to save for the future. Fidelity came out on top for both. Fidelity's 1.19% interest rate on its spending accounts is the highest offered. It also has no maintenance or other additional fees. When it comes to the investing accounts, providers should offer compact, yet diverse investment lineups of high-quality strategies at the lowest possible prices, regardless of whether they are active or passive, wrote Tom Nations, Morningstar's associate director of multi-asset and alternative strategies. In determining its rankings, Morningstar assessed HSAs' menu designs, quality of investments, total costs to the investor and the investment threshold — the amount of money required to be kept in the account before putting dollars towards investments. Five of the 10 providers offer brokerage windows tied to the account, so users can invest in whatever is available on the brokerage platform, Nations noted. Those are Fidelity, First American Bank, HSA Bank, Lively and Optum. All 10 offer investment menus. If your employer offers an HSA, you can compare costs and investment options with the individual plans. You can choose to stick with your employer's plan for your contributions or you can open a separate account. The easiest way to do it from a tax perspective is to fund your employer account through payroll deductions, if that is an option, and then transfer it to your individual account, Nations told CNBC. "You can transfer over the balance fairly regularly without incurring any tax consequences," he said. However, depending on the provider, you may have transfer fees. Deciding how to invest How you will use your HSA will determine your overall investing strategy. Morningstar laid out three different approaches in its report. The first, the bucket approach, entails dividing assets into three needs-based pails that can separate HSA spending money from longer-term investing assets. Near-term money goes into very conservative cash, money markets and short-term bonds. Money that isn't needed for another seven to 10 years is allocated to high-quality bonds. Anything you stash away for more than a decade can go into equities. Balanced and target-risk strategies, like the Vanguard LifeStrategy series, provide a one-stop alternative if you don't want to manage multiple funds, Nations said. These are good for intermediate- to long-term money, which means you may have to shift around money for immediate needs. However, the strategies' managers will rebalance. Lastly, if you can afford to pay your out-of-pocket costs without dipping into your HSA, you can invest for the long term. Nations doesn't suggest treating it like your 401(k) or IRA, however. While you can use your retirement plan as a template for your HSA, consider dialing down the equity risk in case you wind up needing the money. "Don't be a forced seller. Avoid tapping HSA balances during market downturns because doing so depletes reserves and principal that could compound when the markets recover and over the long term," Nations wrote. On the other hand, if you absolutely know you won't need to tap your HSA until retirement, Carolyn McClanahan suggests getting more aggressive in it compared to your retirement plans. "Too many people make their investments all mirror each other. That is not tax smart," she said. Both the Roth IRA and HSA get to grow "tax free forever" so they should be the last thing you touch. When it comes to what to invest in, McClanahan said keep it simple and aligned with your overall investment policy. "Don't get fancy with your HSAs. Use low-cost index funds," she said. Also keep in mind that once you get to age 65, you can withdraw money for non-qualified medical expenses and are taxed on it just like your 401(k) or IRA. "There is no penalty for over-saving in them," Nations said.