Health Savings Accounts, or HSA’s. Everyone seems to love them, and feel like they’re a miracle account. Believe it or not, despite people telling you how great the HSA is, it’s not actually right for everyone all the time. You need to be able to do some analysis on your personal situation to see if an HSA is right for you.
Today I’m going to talk about the mistakes I’ve seen others make when deciding whether to open an HSA, so hopefully you won’t make the same mistake.
But Aren’t HSA’s Always Great?
No, not always.
Now, I know – you’ve already read The Mad Fientist’s article about how the HSA is the ultimate retirement account. Yes, it’s a great type of investment account. But it’s not the best option for everyone all of the time.
For example, while reading an online financial forum a few months ago I saw a poster asking about his HSA situation. Apparently, his spouse has an excellent, low-cost, low-deductible (or perhaps no deductible?) plan. This poster was asking if he should pay thousands of dollars extra out of pocket for his own, separate, worse insurance so he would have the opportunity to contribute to an HSA. That insurance was both more expensive for monthly premium, and more expensive in terms of medical costs.
If you’re not familiar with an HSA, it’s an account that you can save into in order to cover medical expenses. You have to have a high deductible medical plan in order to be eligible. It’s a triple tax advantaged account – money goes in tax free, it grows tax free, and you can withdraw it for medical expenses tax free. If you withdraw it before 65 for non-medical expenses, you pay a 20% penalty. After 65, you don’t pay the penalty but you do pay tax on the withdrawals if they’re not used for medical expenses
I’ve seen variations on this same question repeatedly over the last few years. There’s always someone – a poster on a forum, a commenter on an article, or a person calling into a podcast – that wants to get access to an HSA at all cost. And they think it’s going to be worth paying more out of pocket for their insurance to do so, in higher premiums or higher total medical bills (or both).
Every single year, I get to decide between an HRA (Health Reimbursement Account) plan and an HSA plan at my work. Since I know the benefits of an HSA, I always look closely at that plan option. But it has several significant disadvantages over the HRA plan for my family:
- It costs about the same
- The company contributes less money to the HSA than to the HRA
- The HSA plan has a higher deductible and higher out of pocket maximum than the HRA
The last two points aren’t applicable to a single young person, or to someone who has a very healthy family. But they very much matter to a family that has experienced a horrible medical crisis that continues to reverberate in our lives to this day. I hit my deductible every year, and I’ve hit the out of pocket maximum several times.
If you’re not familiar with those terms, the deductible is how much you need to pay out of your own pocket before the health insurance starts to pay anything. The out of pocket maximum is the total amount you may need to pay every year – after you hit that, you’re in what I call the “double bonus round” where all – 100% – of your health care costs are covered by your insurance company.
This is why personal finance is personal. You can’t just listen to generic advice that works well for someone with a particular financial (and medical) situation. You need to sit down to run the numbers for yourself, for your own life, and your own reality.
This is because of one powerful concept I’ve heard many times before on the Bogleheads forum.
Money is Fungible
What does that mean? Well if you’re simply taking money from your left pocket and putting it in your right pocket, nothing changed in your overall financial picture. If you “save” $1,000 in a savings account but need to put an extra $1,000 on your credit card to do that, you didn’t really save anything. Your net worth is still zero.
The same is true of paying more for the honor of having an HSA plan.
How so? Let me do some math with you. That’s what everyone needs first thing Monday morning, some math.
Let’s say you can save $2,000 into an HSA, Since the HSA contributions are tax deductible, saving $2,000 doesn’t cost you exactly two thousand dollars. You have to calculate how much it really costs you after you take out the tax savings (and the FICA tax savings, if you get the HSA through your employer). If you’re in the 25% marginal tax bracket, pay social security tax of 6.2%, and Medicare tax of 1.45%, saving $2,000 really only costs you $1,347. The actual amount might be lower depending on whether you get state tax savings, or higher if you don’t contribute to an HSA through your employer.
|Federal Tax Savings||$500.00|
|Social Security tax savings||$124.00|
|Medicare tax savings||$29.00|
|Total out of pocket cost||$1,347.00|
So with the HSA you’re paying $1,347, and at the end of the year you have $2,000. That $2,000 can now grow tax deferred and eventually may be able to be taken out tax free.
Now, lets say that in your case, the health insurance plan option with an HSA is going to leave you worse off financially. The premium is higher, your medical expenses are higher, and/or your deductible is higher – all causing you to pay more out of pocket this year for the privilege of having access to an HSA.
How much extra would you have to pay before having the HSA is going to leave you, in total, financially worse off? $654 – the amount you saved on your taxes, plus a dollar. Once you spend that six hundred fifty fourth dollar, you now officially haven’t saved anything over opting for a ROTH.
|Your Real Cost After Tax Savings||$1,347.00||$2,000.00|
|Extra costs you pay||$653.00||$0.00|
|Total real cost to you||$2,000.00||$2,000.00|
Why is that? Remember, money is fungible. If you take the less costly option, you can take the extra money you saved and use it to invest into the Roth IRA. The Roth is not tax deductible, but instead grows tax deferred and can be taken out tax free – just like the HSA. And unlike the HSA, it can be used tax free for anything upon withdrawal. This benefit starts at 59 and a half, not 65.
So the net effect on your wallet – the real cost for making this investment choice – is exactly the same. As soon as you have to spend $654 or more for the privilege of an HSA, you are – in total – financially worse off.
I’ve found a lot of people just don’t understand this concept. Instead they mentally bucket their money into different categories. That’s why people don’t get that investing $5,500 into a Roth and investing $5,500 into a 401k is not the same. Investing $5,500 into that Roth really cost you $5,500 of your net income, but you have to invest $7,333 into a 401k for it to cost you $5,500 (assuming again 25% tax bracket).
Other Potential HSA Pitfalls
When you’re running your own calculations, you need to be on the lookout for other potential HSA investment pitfalls. Why? So you can do a real, mathematical comparison between your plan options. Here are 3 other pitfalls to look out for
- The cost of the plan – This is going to depend on your employer. Many employers offer an HSA through one specific company. You need to check out how much that company charges for the privilege of having an HSA. There may be a flat fee per month/year. Perhaps there’s a fee that increases with your account balance. Or it could be there’s an account fee as well as additional investment fees. Look closely at the fees you’ll be paying when deciding if this is a good option for you
- Hidden cost of the plan – Also called cash drag. Many HSA providers require you to keep a specific dollar amount in cash. This is fine if you’re using it for ongoing medical expenses, but not so great if you’re using it as a retirement account. Be sure to know if this is the case for your plan
- Investment options – Some HSA providers have great investment options, including index funds. But others don’t. Some are chock-full of poorly performing actively managed funds. Take a close look at what options are available to you to see if they’re good – or not so great.
A Word About The Great Unknown
No one really knows how much they’re going to pay in medical expenses during the year. If you’re young, healthy, and single, you probably think you’re maybe going to pay a few hundred dollars – if that. If you’re older, less healthy, or have a family, you probably expect to pay more. This is unfortunate, because the amount you have to pay in medical costs is usually a key part of the calculation.
Being young and healthy is no guarantee that nothing will go wrong. I have a high school friend who passed away in his early 30’s of brain cancer – only a few months after the birth of his daughter. A friend of my husbands, the single mother of two young kids, passed away a few years ago at 40 from blood cancer. And my husband almost died of septic shock at 37, when I was 31. So unlike many others my age, I’ve very much aware that an extreme medical crisis can hit at any time.
Just remember that whenever you’re making these calculations, the medical expenses are the part where you just don’t know what will happen. I would recommend calculating three scenarios – “best case”, “average”, and “worst case” – when deciding which plan option is right for you.
It’s Not All Bad
Lest you think I’m an HSA hater, I’m really not. I think it can be a fantastic option for some people – and the triple tax advantage can be very powerful. Here are seven times it might be a great option for you:
- You’re already maxing out other retirement account options
- You have great investment options in your HSA, with low costs
- You don’t expect to have a lot of out of pocket medical costs
- The HSA plan is not more expensive than the alternative
- You don’t have any alternatives
- You’re self employed, and forced to get a high deductible plan
- You’re not eligible for a Roth
If I’ve missed some other times when an HSA is a great option, let me know in the comments.
There is no such thing as a perfect investment option. Each way you choose to spend or invest a dollar of your money has pros and cons. This is why it’s important that you educate yourself, look closely at the options available to you, and run the numbers for yourself in your own situation. You might just be surprised at the outcome.
What do you think about HSA’s? Have you ever run the numbers for yourself? What are other disadvantages I might have missed? Let me know in the comments.
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