For Some, HSAs Can Be Attractive Wealth Builders

Health Savings Accounts aren't necessarily just about health. They can also be about wealth.

HSAs have mostly been described as a tax-advantaged way to save for medical expenses and pay for them as they come up, before or after retirement, rather than as a long-term savings option that might compete with or supplement individual retirement accounts or 401(k) plans.

But given their tax advantages, HSAs, which can only be opened when paired with high-deductible insurance plans, can under certain circumstances be attractive wealth builders, even considering pitfalls like fees and an often narrow array of investment options. That's especially the case if you're healthy enough to be able to avoid spending through your deductible -- or can afford to leave money in your HSA and use after-tax dollars for medical expenses.

"If you're looking purely at the tax advantages, then HSAs are ahead of all the IRAs," says Randy Gardner, a certified financial planner and a professor of accountancy at the University of Missouri-Kansas City.

HSAs FOR RETIREMENT

Pros:
• You fund them with pre-tax dollars
• Money for medical expenses grows tax free
• Money for medical expenses can be withdrawn at any time
• At 65, you can use money for non-medical items on a tax-deferred basis
• There's no contribution cap based on income
• You're not required to withdraw the money when you're older

Cons:
• Fees
• Investment options may be limited
• High-deductible insurance may not be right for you
• HSAs are relatively new, and may be subject to glitches

Here's why. With a 401(k) or traditional deductible IRA, you generally contribute money that isn't initially subject to income taxes, and that money can be invested and (hopefully) grow. Once you're old enough to withdraw from either account without penalties, the money you take out is taxed as income. With a Roth IRA, earnings on your investments are tax-free, as long as you've had the account for at least five years and generally you're at least 59 1/2 when you withdraw the earnings. But you pay taxes up front, since you can only contribute after-tax dollars to a Roth.

HSAs, in contrast, combine the best features of both -- letting you avoid taxes on the front end and the back end. You can put pretax dollars in. That money can grow and be withdrawn at any time in your life, tax-free, as long as you spend it on qualified medical expenses. (This publication serves as a general guide to what's qualified.)

Meanwhile, once you're 65, if you're lucky enough to have limited medical expenses, you can spend your HSA money on other items without penalty. Money that's withdrawn for other expenses gets taxed as income, similar to what's done with a 401(k) or traditional IRA. (With a Roth, you can withdraw the amount you've contributed at any time, for any purpose without paying any taxes or penalties.)

Assuming you can afford to keep HSA dollars stowed away, "they're probably better off being reserved for retirement," says Stephen Lovell, a certified financial planner with Forsyth Heritage in Walnut Creek, Calif.

Say, for example, you want to put $1,000 of your wages into an HSA. The money generally won't be taxed up front, so the full $1,000 will go into your account. (In some cases, you may end up paying taxes such as payroll or state taxes on wages, which would lower the figure.) If the money grows at a rate of, say, seven percent, it will turn into $1,070 by the end of one year.

Now say you decide to devote that same $1,000 to a Roth IRA. First, you'd have to pay taxes on the wages. So if about 30% of your paycheck normally goes to taxes, your $1,000 of earned income will turn into $700. If you put that into a Roth IRA and it grows at a seven percent rate, it will be $749 by the end of the year. That's $321 less than you'd have in an HSA. Over time, those differences compound.

Some other wealth-building strengths of HSAs: you can contribute to them regardless of your income, and you never hit an age when you're required to start taking some of your money out. (You do, however, have to stop contributions once you're enrolled in Medicare.)

So HSAs have their advantages. But there are some potential issues to keep in mind.

One big factor is that you're required to have an eligible insurance policy with a high deductible -- at least $1,000 for singles and $2,000 for families in 2006 and $1,100  for singles and $2,200 for families in 2007 -- to open an HSA. "Whether that's a good deal or not is a much more complicated question," says Jon Kessler, chairman of WageWorks Inc., a San Mateo, Calif. company that administers HSAs and other tax-advantaged accounts for employers.

High-deductible plans often have lower premiums than other insurance plans, but the tradeoff is that you risk spending a lot of up-front dollars if you get sick. HSAs let you use pretax money for many of those expenses. But if you want your HSA dollars to grow substantially for retirement, you'll have to be able to afford to leave the bulk of them in the account and pay for current medical expenses with after-tax dollars, says Clarence Kehoe, a tax partner at Anchin Block & Anchin LLP in New York. The younger you are when you start saving, the more your HSA dollars will have increased by the time you retire, he says.

Starting early is especially important, because of another issue with HSAs: The amount you can contribute to them is limited. The most you can put in is whatever the deductible on your health insurance is, with contributions topping out in 2006 at $2,700 for singles and $5,450 for people with family coverage. For 2007, regardless of your  deductible and when during  the year you obtain the high-deductible  plan, you can contribute the annual  maximum of $2,850 for singles and  $5,650 for families. (Consumers age 55 and older who aren't enrolled in Medicare can make additional "catch up" contributions of up to $700 in 2006 and $800 in 2007.)

In contrast, federal law allows individuals to contribute up to $15,500 to 401(k) plans in 2007, or $20,500 if you're 50 or older, though some plans may set lower limits. Your employer may even match some of your contributions, creating a big incentive to put money in your 401(k) first. The maximum contribution to traditional and Roth IRAs is generally $4,000 for people under age 50, and $5,000 for those 50 and above for 2006 and 2007.

Some other issues: Since HSAs are relatively new — they were created in late 2003 – using them may present glitches, and not all major financial institutions are offering them. At firms where HSAs are available, often there are fees and a limited array of investment options.

"There's a great deal more choice available for IRAs and Roth IRAs than there are for health savings accounts," says Steven Martin, a certified financial planner at Beacon Financial Planning Services Ltd. in Plainfield, Ill.

To open an HSA at J.P. Morgan Chase & Co., for example, you have to be insured by a carrier that's working with the company. Fees and investment options depend on who your insurer is. There is sometimes a set-up fee of about $20, and generally there are monthly fees of about $3. HSA customers normally need to have at least $1,000 to $2,000 in their accounts before they can invest the money in mutual funds. Once they have enough in their accounts, they generally have six to 10 funds to choose from.

Mellon Financial Corp. offers its customers three mutual fund options once they have $2,500 in their accounts.

As HSAs become more common and the balances in them grow, it's likely that the fees will fall and the investment options will widen, says John Prince, senior vice president with JPMorgan Chase Treasury Services.

Finally, HSAs don't necessarily have big advantages when it comes to passing them on to your heirs. If you leave your HSA to a surviving spouse, it will be treated as your spouse's HSA. But if you leave it to anybody else, it stops being an HSA and becomes taxable to the beneficiary in the year in which you die, according to the Internal Revenue Service.

Even with these issues, an HSA may make sense for some people. As Mr. Kessler of WageWorks says: "Just think of it as another retirement savings vehicle, with a few quirks."

By Sarah Rubenstein
The Wall Street Journal Online
March 2, 2005
(updated for 2007)