Morningstar: What happens to your HSA in retirement?

Health savings accounts can be valuable components of individuals’ savings toolkits, especially for those who can afford to pay their actual healthcare expenses out of pocket while leaving their health savings account assets in place to grow.

If investors are able to pay out of pocket for healthcare costs and allow their HSA accounts to grow, the HSA assets can better harness the power of compounding, and the tax benefits are also more valuable when stretched over a longer period of time.

Before they employ an HSA as a long-term investment vehicle, though, investors need to do their due diligence.

Let your HSA money grow

The starting point for thinking about how to invest your HSA is to consider when you would actually spend the money.

As noted above, HSAs enjoy triple tax-advantaged status, and the benefits of that tax-free compounding increase the longer the money is invested. Let’s say an investor contributed $6,000 to her HSA and earned a 5% annualized return over the ensuing 10 years. She’d have nearly $10,000 at the end of the 10-period, and she wouldn’t owe any taxes along the way.

Meanwhile, an investor who used after tax dollars to contribute to a taxable brokerage account would steer $4,500 into the account—the $6,000, less taxes, assuming she’s in the 25% income tax bracket. Assuming a 5% annualized return on her money, she’d have $7,412 in the account 10 years later. She’d then take a tax haircut on the appreciation when she pulls the money out; assuming a 15% capital gains rate, her take-home return would be less than $7,000.

How to think about HSA asset allocation

HSA assets can be managed in line with other retirement assets; the longer the time horizon until spending, the more aggressively positioned those assets should be. But as retirement draws near, it makes sense to think about a liquidation strategy, based on anticipated healthcare spending needs. To project spending, it’s helpful to review which expenses qualify for tax-free withdrawals.

Importantly, premiums for Medicare supplemental policies don’t qualify as tax-free withdrawals, though Medicare insurance premiums (for Parts B, C, and D), long-term-care insurance premiums (up to the IRS limits), and out-of-pocket pharmaceutical costs, among others, would all be eligible.

Armed with an estimate of annual healthcare spending needs, a retiree can then position the assets in the account.

Where does an HSA fall in the retirement distribution queue?

In addition, retirees will also want to consider how their HSAs fit in with other assets in the distribution queue. The HSA should logically come after withdrawals from taxable accounts and traditional IRAs and 401(k)s. That’s because HSAs enjoy tax-free compounding and withdrawals are tax-free for qualified healthcare expenses, so it’s valuable to hang on to those benefits for as long as possible.

But how about withdrawals from HSAs versus Roth IRAs? Withdrawals from HSAs are tax-free, just like Roth IRAs; nor do RMDs apply to either account type. But inherited HSAs don’t have the same tax benefits that Roth IRAs do.

HSA investors should also give due consideration to the beneficiaries of their accounts. While naming a spouse as a beneficiary can make a lot of sense, the last surviving spouse might consider expediting expenditures from the HSA and/or naming a charity as the HSA beneficiary. In contrast to an HSA inherited by a human beneficiary who’s not a spouse, the charity wouldn’t owe taxes on the inherited amount.

Christine Benz is the director of personal finance and retirement planning at Morningstar. Margaret Giles is a senior editor of content development at Morningstar.