How much should I fund an HSA? Is there a danger in over-funding one?

Question

I'm reviewing my options for health insurance during open enrollment and one of them is a HDHP/HSA option. I hear these are best for young people without chronic conditions etc. I think I fall into this category, so I'm considering it.

I'd definitely try to get at least one year's deductible into the fund, to avoid paying taxes on medical expenses. My question is a bit more long term though: is there a danger or risk in funneling as much money as possible into an account earmarked for health expenses? I'm not sure whether I should be just maxing it out or trying to target keeping around one or two year's deductible and investing the difference in other accounts (403b, Roth IRA, paying down loans, etc.)

Answer 1

HSAs are very similar to IRAs. Any investment returns grow tax-deferred and once you reach age 59 1/2 65, you can withdraw the funds for any purpose (subject to ordinary income tax), just like a traditional IRA. If you can afford to do so, I would recommend you to pay medical expenses out-of-pocket and let the funds in your HSA accumulate and grow.

In general, the best way to allocate your funds is in the following order:

1. Contribute to a 401(k) if your employer matches funds at a substantial rate

2. Pay off high-interest debt (8% of more in current environment in 2011)

3. Contribute to an IRA (traditional or Roth)

4. Contribute to an HSA

5. Contribute to a 401(k) without the benefit of employer matching

One advantage of HSAs versus IRAs is that you don't have to have earned income (salary or self-employment income) in order to contribute. If you derive income solely from rents, interest or dividends, you can contribute the maximum amount ($3,050 for individuals in 2011) and get a full deduction from your income (Of course, you will need to maintain a high-deductible health plan in order to qualify).

One downside of HSAs is the lack of competitively priced providers. Wells Fargo offers HSAs for free, but only allows you to keep your funds in cash, earning a very measly interest rate, or invest them in rather mediocre and expensive Wells Fargo mutual funds. Vanguard, known for its low-fee investment options, provides HSAs through a partner company, but the account maintenance charges are still quite high.

Overall, HSAs are a worthwhile option as part of your investment plan.

Answer 2

No danger. You can get in a car accident, break your leg skateboarding, or otherwise wind up in the hospital like anyone else. You can also get the money back, with a tax penalty, but you probably will never need to if you are responsible and live within your means.

Do you need a wake up call about what things can cost? I knew a college student who broke his leg skateboarding and didn't buy the ~$100/semester health insurance. He had to have a rod put in his leg and it was ~$30,000. Obviously he didn't have the money and the hospital agreed to put him on some kind of payment plan. I suppose bankruptcy was an alternative.... but either way, not a great way to start out in life.

Any time you can defer payment of tax for decades or buy something with pre-income tax money, it is like instantly earning 20% (or more) on your money. I believe you can pay for eyeglasses and dental out of an HSA as well.

So I wouldn't go overboard on an HSA or IRA if you have big credit card debts, if you do have room for savings it is dumb not to be putting money in the HSA and IRA/401k.

Take a look at HSA bank for a low fee home for your money. They pay interest on over $3,000 (but like most banks, not much). The fees for being under $3k are currently around $2 a month. Don't worry about investing the HSA money until you have like $10,000 in there, which will be a while.

Answer 3

HSA's are one of the few accounts where the money is both tax free going in and coming out. For long term savings, the only account that might beat that is a 401(k) with an employer match.

Unlike an FSA, the money can stay in the account indefinitely. You can also use the money to pay medical insurance premiums once you separate from the employer.

An HSA combines the best features of a FSA, Roth account, and IRA/401(k) account. As such I think there is rarely a reason not to max one out, and in fact I think it is worth it to go out of your way to get access to one.

There are some drawbacks, of course. If you don't use the money for medical expenses, it may be taxed and perhaps penalized. Getting access to one can be tricky (you have to be covered by an HDHP, but not by a non-HDHP, nor by an FSA). The low contribution limits make it hard to build up a large balance. Many providers charge a monthly fee of $1 to $4 if you want to invest the balance (small, but it adds up, especially given the low balance per previous sentence).

Answer 4

The limits on an HSA are low enough that there's no real danger of overfunding it. The limits max out at (as of 2011, for an individual) at just over $3000 per year.

Sometime in the next few years, you will have more than $3000 in health care expenses. It might be something like a car accident, acid reflux, a weird mole that the doctor wants to check out, a broken toe, a few nasty cavities that need to be filled, an expensive antibiotic, or something else entirely. Or, it might be something less dramatic, getting eaten away by copays and contact lenses.

When that happens, you want the peace of mind that you can pay for your deductible plus any other expenses. Keep in mind that even a $5000 deductible can cost you more than $5000 out-of-pocket; either because of non-insured expenses, or simply an illness that straddles multiple calendar years.

Besides, it's not like your HSA money is going anywhere; even if you never touch it, it's just a savings account that you can't touch until you turn 65. And if you do truly have an emergency, you can get at it if you have to.

Even if your HSA is filled with several years' worth of deductibles, it's still a way to shield thousands of dollars a year from taxes, with luck moving them into lower-tax years 40 years from now. And it's a way that doesn't involve income limits or mandatory withdrawals.

Answer 5

An important risk is that the government may decide to change the rules.

For example, prior to 2011, over the counter drugs like aspirin, Tylenol, Nyquil, etc. were eligible expenses. You could use your HSA money to buy as much as you wanted.

Beginning in 2011, those rules changed. Now, if you want to spend your HSA money on Tylenol, you need a prescription for it. The value of HSA dollars was diminished in the sense that the universe of eligible expenses was diminished.

No one knows what the HSA rules will be in the future. What will be eligible expenses? Who will be eligible providers? What kind of compliance paperwork will be required? What kind of fees will be imposed?

Personally, I'm a great believer in HSAs. I've saved in one for years. But remember that the government makes the rules regarding their use. They've changed the rules to the detriment of HSA owners at least once; I won't be surprised if it continues.