Investing the funds, on the other hand, in a diversified portfolio provides the potential for higher longer-term returns. Particularly for those with a longer time horizon, there’s an opportunity to invest in assets, such as stock funds, that may have short-term volatility but provide higher returns in the long run.
The favorable tax treatment of HSAs makes them even more valuable when invested. A Morningstar analysis found that funds invested in an HSA could potentially triple over 20 years, for a balance 18% higher than the same assets in a 401(k) or IRA account and more than 30% higher than those in a taxable account.
How do you invest your HSA?
You invest an HSA through your account custodian much like you would a 401(k) account. Most custodians offer a menu of investment options, including index funds or exchange-traded funds, from which you can choose. A few HSAs allow for self-directed investments, meaning accountholders can use the account to invest in most types of securities, including individual stocks or bonds as well as alternative investments.
What HSA investment strategies can be used?
As with other types of investment accounts, there are several strategies you can use when it comes to investing within your HSA. These depend on the options available through the accountholders.
Go all in with a target-date fund.
Like retirement accounts, many HSAs offer target date funds (TDFs) as an investment option for participants. These funds hold a mix of stocks, bonds and other types of investments selected based on your projected retirement date. Over time, they shift to more conservative assets to reduce the risk of losses as that date approaches. They’re meant for investors to put their entire balance into the fund, and don’t require rebalancing by the accountholder.
Allocate across multiple funds.
If your client’s HSA offers a variety of stock and bond index or exchange-traded funds or mutual funds, you can help them determine the most appropriate allocation for their financial picture from those funds. These fund options are often similar to those found in a typical 401(k) retirement plan.
Build a custom portfolio.
While most employer-linked HSA accounts offer only fund or cash investment choices, there are also self-directed HSAs, which allow the accountholders to invest much like they would in a self-directed IRA.
The IRS allows HSA rollovers once per year, so clients interested in building a custom portfolio can move the funds out of their workplace account and into a self-directed HSA if they’re interested in investments that are not available in their workplace HSA. Or clients can contribute the cash directly into their out-of-plan HSA and deduct the contributions on their tax returns.
What are the potential drawbacks of HSA investing?
While there are many benefits to investing via an HSA, there are also drawbacks to consider.
The account could lose value over time.
As with any investment strategy, there’s always the possibility that the portfolio could lose value during times of market volatility. Those who need their HSA funds to cover current medical expenses, or those they expect to incur in the next few years, are likely better off keeping some or all of their HSA in cash. Or, they might work to build up an emergency fund with at least enough money to cover the annual out-of-pocket maximum for an HDHP ($15,000 for families or $7,500 for individuals in 2023).
The fees may be high.
The fees associated with HSAs can be higher than some other types of retirement savings. Most employers cover account maintenance fees, which average under $3 per month, per a report from the Plan Sponsor Council of America. The average HSA also has six to 10 additional one-off fees, according to Morningstar.
Account balances might grow too large.
If investments perform extremely well over time, accountholders might have more money than they can use for medical expenses. In this case, they can still make penalty-free withdrawals after age 65 for non-medical purposes, but they’d owe ordinary income taxes on the distribution, meaning they’re treated essentially like 401(k) withdrawals.
A bigger drawback to overfunding HSA accounts is that if you die and want the assets to go to anyone other than your spouse, they’ll likely face a large tax bill. That’s because while HSA ownership can transfer easily to a spouse who is a named beneficiary, the account will convert to an ordinary, taxable account for any other heir, and they’ll have to claim it as taxable income.
Here’s how to get started with HSA investing.
Getting started with HSA investing is fairly straightforward. Most HSAs have an online portal, typically accessible through an employer benefits website, through which accountholders can make changes to their account allocation. If their HSA does not offer investment options, they can open an account at an outside brokerage firm and roll the funds over to start investing.