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Are HSAs a Better Investment Vehicle Than 401(k)s?

Of course it depends on what factors you consider, but when considering the tax advantages, an argument can be made that HSAs are a better investment vehicle, particularly when used only for qualified medical expenses, a new report claims.

HSA Investing: 3 Reasons Investing in an HSA is Not the Same as a 401(k),” a new white paper from Devenir, takes an in-depth look at the benefits and limits of investing in an HSA versus a 401(k).

A section of the report that stands out is a comparison of 401(k), 401(k) plus match and HSA balances after a period of 5 years, 10 years and 20 years, based on a 5% annual return.

The analysis is based on the “after-tax future value” (ATFV) framework provided by Dr. Greg Geisler of the University of Missouri that argues that HSAs can provide more value over time than a 401(k) when accounting for taxes. Under Geisler’s approach, individuals should first contribute the maximum to an HSA and then enough to a 401(k) to get the maximum employer match, followed by a specified pecking order if money is still left over.

One scenario in the report assumes all distributions from an HSA are used for qualified medical expenses (QMEs) with a tax rate of 25% and an initial, one-time pre-tax contribution equal to $6,900 to the HSA, 401(k) and 401(k) with an employer match of $1,000.

In this basic example, the added value of HSA investing amounts to nearly $6,000 over a 20-year investment horizon compared to a traditional 401(k). Even comparing the 401(k) match to the HSA shows a $4,000 difference over the 20-year period. Granted, some of the assumptions used are an oversimplification of what happens in real world situations, but there does seem to be merit in the underlying point, particularly if the HSA is used strictly to pay medical expenses in retirement.

The report further shows the difference in the ATFV between HSAs and 401(k)s across various tax rates over a 30-year period. Even at the lowest tax bracket used in the report (15% in this case), the difference can amount to more than $4,000 over a 20-year period and $7,000 over a 30-year period, based on a one-time contribution of $6,900 and distributions used for QMEs.

Zach Haas, an investment analyst at Devenir and author of the white paper, explains that, “Consumers continue to look for effective ways to navigate their health care savings and understand the advantages HSAs have to offer. Using 401(k)s as a baseline is a great way to tell the value story of HSAs and where they fit in the retirement picture.”

In another illustration, the report looks at the potential impact an HSA can have on health care savings by estimating how long each account could cover health care expenses in retirement. In this case, the report assumes a 15-year retirement period with $275,000 in health expenses and $300,000 saved in each account. Under these assumptions, the HSA paid for an extra 5.35 years of health costs, with the HSA lasting for more than 16 years, while the 401(k) account lasted for only 11 years.

The paper reiterates that 401(k)s are limited to use as a retirement savings vehicle and that distributions are required at age 70½ and will be taxed as income, and subject to a 10% penalty if made prior to age 59½. Conversely, HSA funds are not taxed or penalized as long as distributions are used for QMEs. In addition, HSA distributions after age 65 can also be used for other purposes without penalty but are subject to income tax. Non-QME HSA distributions before age 65 are subject to tax and a 20% penalty.

Factors to Consider

The report emphasizes that HSA investors have some additional factors to consider when making savings decisions that 401(k) investors may not. One of these is the year-to-year variance in health costs and how the possibility of having to make large withdrawals to cover unexpected health care costs could affect their savings plan.

Other factors include the possibility that inflation can “eat away” at the buying power of the HSA balance, as well as considering the real return on investment. For example, the report shows that for 2008, 2011 and 2015 using the real rate of return of an HSA investor fully invested in the S&P 500 would have been negative due to rising medical costs.

The HSA market is undergoing tremendous growth and it is only expected to get stronger, with HSAs projected to exceed $60 billion in assets among nearly 30 million accounts by the end of 2019. HSAs have grown to nearly $43 billion in assets and 21 million accounts as of June 30, 2017, representing a year-over-year increase of 23% for HSA assets and 16% for accounts.

And while there is huge potential in the growth of HSAs, advisors should understand the layered complexities before urging clients to offer HSAs, as noted in a recent NAPA Net post.