HSAs come with pitfalls — here's how to avoid them

Health savings accounts are growing rapidly as employees tap into the vaunted "triple tax free" advantages, but those benefits come with some caution for financial advisors and their clients.

Pretax contributions, untaxed investment earnings and penalty-free withdrawals for qualified medical expenses provide ample appeal for HSAs as a savings vehicle for healthcare costs or even retirement in the future, according to five financial advisors and other experts who spoke with Financial Planning. On the other hand, HSAs carry restrictions on the amount of contributions by savers and employees, the requirement that the account holder be enrolled in a qualifying high-deductible health insurance plan and, sometimes, fees and investment characteristics that could make the tax perks a far less attractive proposition.

"There are a lot of benefits to having a health savings account such as pretax savings, tax-

deferred growth and tax-free withdrawals for qualified expenses," Sarin Barsoumian, the founder of Burlington, Massachusetts-based SMB Financial Strategies, said in an email. "However, the out-of-pocket deductible is high, so it's important to consider your (and your family's) medical needs. If you (or a family member) are under a preventative care plan and only need your annual covered appointments, then an HSA makes sense. If you (or a family member) have a medical condition, see a specialist or other health considerations, then you should take some time to consider what your annual out-of-pocket costs would be."

Although "HSAs have many exciting features to them," clients should remember that they're "only available for contribution for people who are under a qualified high-deductible health plan," agreed Autumn Knutson, founder of Tulsa, Oklahoma-based Styled Wealth.

"For people who anticipate high healthcare costs in a given year, it is possible an HSA medical plan is not the best option for you for that year," she said in an email. "If you are not sure whether a [qualified high-deductible health plan] makes sense for you, seeking fiduciary financial advice on this consideration may be helpful to know under what conditions an HSA could make sense in the context of your broader financial circumstances and plans."

Still, the tax savings and other features of HSAs often prove enticing for the right client, noted Fahmin Fardous, a financial planner with Philadelphia-based Zenith Wealth Partners.

"There is no use-it-or-lose-it rule by the end of the year. It stays with you even if you change your employer," she said in an email. "It's an unofficial medical individual retirement account. After 65, you can use the money from the HSA for anything you like. You just have to pay tax on the amount used if it's not a qualified medical expense. Key point, you cannot contribute to HSAs anymore once you're enrolled in Medicare."

READ MORE: The HSA 'deathbed drawdown': Making tax-efficient distributions when there isn't much time

By the numbers

Those kinds of qualities are drawing savers to HSAs — with the caveat that many account holders' employers only offer them high-deductible plans, according to a report earlier this month by the Consumer Financial Protection Bureau, a federal watchdog agency. In the past 10 years, the number of HSAs has tripled to 36 million and their assets have soared by more than 500% to $116 billion. The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 created HSAs and "the modern conception" of high-deductible plans, the report said. 

Low interest-rate yields for the savers and fees for monthly maintenance, account closing and, in some cases, printed account statements, can often add up into what the consumer watchdog described as a "captive consumer model" for HSAs. (The report generated pushback on its findings from the American Bankers Association, which advocates for banks that can be HSA trustees holding the savers' assets or work with third-party institutions that act as trustees.)

"Although Americans can select their HSA, the reality is that people do not typically choose these accounts," Rohit Chopra, the director of the bureau, said in a statement. "Most HSAs are offered through and sold to employers and insurance companies. Consumers often end up with a financial product that was designed to meet the needs of employers and insurance companies instead of health care users."

Furthermore, most HSA holders "do not take complete advantage of the tax benefits HSAs offer" since "average contributions are well below the statutory maximum, most account holders take a distribution from their HSA and relatively few account holders invest," according to the latest annual trends report by the Employee Benefit Research Institute, an industry research organization. Average assets per account climbed 7% to $4,607 in 2022, and 45% of HSAs received contributions from employers.

"On average, accountholders appear to be using HSAs as specialized checking accounts rather than investment accounts, though this behavior appears to change the longer an HSA owner holds an account," the report said. "Over the past decade of conducting longitudinal analysis of its HSA Database, EBRI finds evidence that the longer an accountholder has had their HSA, the higher the likelihood that the accountholder invests their HSA in assets other than cash, in addition to contributing more on average and enjoying higher account balances."

Policymakers viewed HSAs "as a means to help people better weather high deductibles in their health plans," Jake Spiegel, a research associate with the institute who co-authored the report, said in an interview.

"Broadly speaking, if you want people to enroll in a high-deductible health plan, you have to offer them some sort of a carrot," he said. "People who have higher deductibles aren't necessarily good at figuring out what health care they'll actually need. With these higher-deductible health care plans it puts people in the position to be more discerning about the health care they're pursuing."

Advisors and wealth management firms have "so much opportunity" to speak with clients about the possible merits, according to Karen Volo, the head of health and benefit accounts at Fidelity Investments, where HSAs reached a record $23.9 billion earlier this year.

The advisors could be "bringing forward something the customer might not have understood before," she said in an interview. "You should be talking to them about how that account can contribute to your overall financial planning picture, as well as your retirement saving picture."

READ MORE: HSAs should be promoted as way to supplement retirement savings

Not yielding gains

Most HSA holders aren't yet using their accounts in that manner, though. 

While the percentage of HSAs with assets in investments other than cash has surged by 11 percentage points since 2011, only 13% are using that capability, the institute's report showed. 

With every dollar leaving an impact on health care spending and compounding gains for clients' retirement nest eggs, those decisions make a big difference. For HSA cash assets, only Fidelity out of a group of 10 of the largest trustees paid more than 1% interest to savers at a time of high rates, at 2.69%,  according to an analysis by Morningstar last year that the consumer bureau cited in its report. And just one other HSA trustee, First American Bank, provided interest yields above 50 basis points.

Fidelity's yield "is over 13 times higher than the second most generous HSA," the consumer bureau's report said. "Notably, competitive pressure has not driven other players to offer higher rates. Bank and non-bank HSA trustees may resist raising interest rates because they make money on the spread between market interest rates and the rate provided to consumers. Banks earn money from interest rate spread directly, and non-banks do so indirectly via earnings from their bank partners. By not sharing these extra earnings with consumers, HSA trustees boost their bottom line."

Out of the four largest HSA trustees including Fidelity, HSA Bank, Optum and HealthEquity, only Fidelity does not have a minimum account balance for investing or charge an additional fee for it, the report said. HealthEquity requires a balance of $500 with an extra monthly cost of the greater of 3 basis points or $10; HSA Bank mandates $1,000 with a quarterly fee of the greater of $1.50 or 7.5 basis points; and Optum enforces a minimum of $2,000 with a monthly investment fee of 3 basis points capped at $10. Fidelity charges up to $4 for monthly maintenance fees, which the bureau noted are paid by the employer for active staff 58% of the time across the industry and 34% of the customers themselves.

There isn't "one single, satisfying answer" as to why there aren't more HSA accounts with noncash investments in them, Spiegel said. The "behavioral friction" of minimum balances, cash-flow concerns with medical expenses, worries about market risk or the simple reason that clients haven't had the accounts long enough could be tamping down the investing, he said. The available investment lineups may not look very appealing to the clients, either.

"Some people get defaulted into a stable-value fund," Spiegel said. "My understanding is that investment lineups have gotten a little better. A decade ago, 15 years ago, you might be stuck with a super-high-fee index fund. By and large, I think that has fallen by the wayside."

Many of "the higher-balanced participants are taking advantage of the investing opportunity" at Fidelity, according to Volo, who noted that the 22% rate at the firm spans 49% of the firm's HSA assets. 

"Our goal is to move somebody from a spender to a saver to an investor," Volo said. "We're hoping that they're saving more than they're spending so that they're starting to realize the value of that account."

READ MORE: Tips for using a 'medical IRA' that offers triple the tax savings

Practice management lessons

Some fundamental factors like the basic need for more money are playing into the low share of HSAs with other investments besides cash, according to advisors. To begin with, they're still "somewhat new and adoption is taking time," Barsoumian said. 

"Most HSA account holders don't invest any of their assets because they have a high deductible

plan and high out-of-pocket costs," she said. "I recommend maintaining one year of max out-of-pocket expenses in their HSA and investing the balance exceeding that dollar amount."

Some may not even know that there is usually a minimum asset requirement they must meet before they invest or that they can do so in the first place, Knutson said. For those "able to save beyond their anticipated healthcare needs in the short term," HSAs "can be a powerful tool and worth the time or financial investment of learning how to optimize these accounts for long-term wealth building," she said.

"These conditions are able to be put into place via many HSA provider platforms so that if the cash balance goes below the threshold set, then the future funds will go to cash until that threshold is met and then resume contributions going toward the invested balance," Knutson said. "There may also be some hesitation and discomfort in not knowing what to invest the funds in, which is where a fiduciary financial planner could come in to help get you on the right track for your risk tolerance and goals and put your money toward the best financial outcomes."

Advisors ought to mention the possibility of investing with any clients who have an HSA, Fardous said. 

"Most people aren't aware that the account can be invested," she said. "Whenever a client has an HSA or it's recommended by their financial advisor, they should advise the client to invest the funds. The way to ensure the client is actually invested is by following up and having it as an action item during their routine conversation."