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An HSA Watershed Moment?

“I asked a prospective retirement advisor whether I should contribute the next $5,000 of retirement savings into my company’s traditional 401(k), a Roth 401(k) or my HSA. He proceeded to tell me . . . “

William G. (Bill) Stuart

Director of Strategy and Compliance

April 26, 2018

Sometimes we know when we’re right in the middle of an historic event. We watched the break-up of the Soviet Union before our eyes three decades ago, an event that reversed 70 years of history. More recently, we knew during, and immediately after the terrorist attacks in September 2001, that our lives would never be the same. We didn’t know exactly how our lives would change, but we knew, as my parents’ generation knew Dec. 7, 1941, that life would never be the same.

Sometimes, we don’t realize the impact of a single event on history until long after it happens. The New England Patriots lost more regular-season games than they won (.470 winning percentage) from 1960 through the end of the 2001 regular season. Then, in January 2002, a controversial officiating call, a 45-yard field goal in a fierce snowstorm with 27 seconds left in regulation, and a scoring drive in overtime propelled the team to five Super Bowl titles and a .773 winning percentage in regular-season games since. No one watching the “Snow Bowl”/“Tuck Rule” game knew that it would be the fulcrum for a subsequent generation of gridiron success.

I believe that we are experiencing a similar watershed event in the world of Health Savings Accounts. The event isn’t being televised, there are no cheerleaders and a hooded figure isn’t visible on the fringes of the market. Nevertheless, I believe that it’s happening. If so, it won’t be the first fulcrum in the development of HSAs, but it will have the greatest financial impact on tens of millions of Americans.

HSA Watersheds I and II

The first HSA watershed occurred in 2003. Late that year, President George W. Bush signed the Medicare Prescription Drug, Improvement and Modernization Act into law. The bill created Medicare Part D, giving seniors their first access to prescription-drug coverage regulated by the federal government and heavily subsidized by taxpayers. The legislation also expanded the experimental Medical Savings Account program by allowing all Americans who enrolled in coverage that met certain criteria to open and contribute to a tax-perfect financial account, and HSA to reimburse current and future health-related expenses.

The second HSA watershed took place in late 2006, when a lame duck Congress passed the Health Opportunity Patient Empowerment (HOPE) Act  of 2006. This legislation expanded HSAs in several important ways.

First, it allowed HSA owners to contribute up to the statutory annual contribution maximum. Prior to 2007, contributions were limited to the lower of the deductible or the statutory contribution ceiling. This simple change allowed individuals who met their annual deductibles to make additional contributions to cover other current expenses (like dental, vision and medical cost-sharing above the deductible) or build medical equity to reimburse future expenses.

Second, the Act contained the Last-Month Rule, which allows individuals who are HSA-eligible by Dec. 1 to make a full HSA contribution for that year (subject to completing a testing period). Before then, HSA owners’ only option was to pro-rate their contributions, which in the case of individuals whose employers had late-year anniversary dates with contribution limits lower than their deductible responsibility.

Third, HSA owners were allowed to execute one-time rollovers from an Individual Retirement Arrangement, a Health FSA or an HRA into their HSAs. The Health FSA and HRA rollover provisions proved to be a dud, as the law was written in a way that allowed few individuals to qualify. The IRA rollover was and remains a key provision because it allows savvy individuals to move funds from an account whose distributions are always taxable (a traditional IRA) into an HSA with tax-free distributions for qualified expenses.

These three key provisions, contributions to the statutory maximum, the Last-Month Rule and rollovers from IRAs, repositioned HSAs forever. HSAs went from being little more than Health FSAs with a carryover feature to a combination reimbursement-investment account. The world would never be the same.

HSA Watershed III?

Yet for a decade since the HOPE Act, many of us in the HSA industry have been waiting for professional financial, investment and retirement advisors to comprehend fully the value of HSAs as financial, not merely medical reimbursement accounts. The little secret of the post-HOPE versatility of HSAs was confined largely to those of us who are directly involved in HSA administration and a handful of benefits advisors and employers who saw the vision.

That tide seems to be turning. Last spring, an industry colleague excitedly told me, “They finally get it.” He was referring to the annual meeting of a major  professional investment organization, at which the group’s leader asked attendees whether a 401(k) or an HSA was a better vehicle for retirement savings. Only 20% raised their hands in support of the HSA.

“Eighty percent of you are wrong,” the speaker noted.

And in most situations, I believe, he’s correct.


Traditional and Roth 401(k) and IRA plans, as well as other more narrowly available retirement plans (like SEP IRA, SIMPLE IRA and Keogh plans) are tax-advantaged. Owners receive a tax break when they contribute or when they make distributions. Owners build balances tax-free within the accounts. At some point, either on the front-end when they make contributions or at the back-end when they withdraw funds, owners pay taxes.

HSA owners pay no federal income or payroll taxes, and in all but three states (Alabama, California and New Jersey) pay no state income taxes on contributions. By contrast, all Roth 401(k) and IRA contributions are post-tax. Even traditional 401(k) and IRA plans, to which federal and state income taxes aren’t applied, are subject to federal payroll taxes (7.65% assessed to employee and employer alike). This is perhaps the most overlooked benefit of HSAs by those who view traditional 401(k)/IRA and HSA contributions as receiving equal tax treatment.

HSA owners pay no taxes when they withdraw funds for qualified expenses. By contrast, traditional 401(k) and IRA distributions are taxed as ordinary income. Roth 401(k) and IRA withdrawals are tax-free.

The Triplets Save

The differences in tax treatment lead to very different spending power within each account. Let’s consider a set of triplets that all decide at age 35 to save $3,000 for retirement. They then increase that figure by $50 annually.

Ashley establishes a Roth IRA. Her net contribution is only $1,871, since her contribution is subject to payroll taxes (7.65%) and combined federal and state income taxes of 30%.

Bentley puts her money into a traditional 401(k). Her net contribution is only $2,771, since she is assessed payroll taxes on her contribution.

Caitlyn opens an HSA. Since her contributions are free of federal and state income taxes and payroll taxes, the full $3,000 goes to work immediately.

For the next 29 years, each increases her annual contribution by $50 and enjoys 7% annual growth.

What happens after 30 years, when they reach age 65? Ashley’s Roth IRA has a balance of $205,000, Bentley has amassed $304,000 in her 401(k) and Caitlyn has a $329,000 balance in her HSA.

The Triplets Spend

Beginning in Year 31, they incur $10,000 of medical expenses in Year 31, a figure that increases by 5% annually as medical inflation outstrips the economy-wide rise in prices. Their tax rates in retirement decline to 20% and their investment return is only 5% (reflecting a more conservative investment strategy to preserve capital). You can quibble with these assumptions, but slight adjustments don’t change the overall picture materially.

Ashley withdraws $10,000 from her Roth IRA in Year 31. That figure increases by 5% annually through Year 51 (age 86), when she exhausts her Roth IRA balance.

Bentley withdraws $12,500 in Year 31, since her withdrawals are subject to 20% federal and state income taxes. This figure increases annually by 5%. She exhausts her balance in Year 56, when she’s 91 years old.

Caitlyn withdraws $10,000 in Year 31, then increases that figure by 5% annually. She doesn’t deplete her balance until year 65, when she’s 100 years old.

Let’s look at it from another angle. We’ll assume that each sister lives to age 100. In that case, Ashley must withdraw $663,000 from taxable accounts to pay her remaining $531,000 in medical bills between Year 52 (age 83), when she depletes her Roth IRA account, and Year 65.

Bentley must withdraw $444,000 to pay the expenses that she incurs in Year 56 (age 86), when she exhausts her 401(k) balance, through Year 65.

Caitlyn must withdraw only $27,000 from a taxable account to pay the balance of her medical expenses in Year 65 (age 100), when she exhausts her HSA balance mid-year.

The Secret’s Out

Think about this situation as you decide where to put your next dollar of retirement savings. While it’s impossible to know how long we will live, would you rather that the same sacrifice of current consumption pay your medical expenses until age 86, age 91 or age 100?

The same sacrifice of current consumption during the triplets’ working years lead to very, very different retirement outcomes.

So, the secret’s out.

Think about this illustration as you discuss your retirement savings strategy with your personal advisor (rather than accepting this column as investment advice, which it is not, rather than as information to discuss with a licensed professional). I did so two weeks ago. I asked a prospective retirement advisor whether I should contribute the next $5,000 of retirement savings into my company’s traditional 401(k), a Roth 401(k) or my HSA.

He proceeded to tell me about the relative advantages and disadvantages of a traditional 401(k) vs. Roth 401(k), including my tax situation and time horizon. He dismissed the HSA, not because it’s not a good option, I believe, but rather because it was obvious that he didn’t understand the tax advantages of an HSA or the appropriate use of the account as a tax-perfect vehicle in which to build medical equity.

My prospective advisor doesn’t fully grasp the power of HSAs. And he probably represents a majority of the population of financial planners, investment advisors and retirement specialists. I am convinced, however, based on my survey of the popular press and conversations with influencers in these professional fields, that more and more advisors are beginning to understand that HSAs can play an important role in a successful retirement plan.

We’ll know only in retrospect whether we’re living in a watershed year in the history of HSAs. Let’s hope that this change is occurring now, rather than in the future. The sooner HSAs are understood as tax-perfect retirement accounts, the more individuals can enjoy a more financially secure retirement.

What We’re Reading

Our friend Paul Fronstin, Ph. D., at the Employee Benefit Research Institute (EBRI) always provides excellent survey results and analysis to the medical coverage industry. In a recent study, he analyzes the differences in relationships with clinicians by age.  He reports that younger workers are far less likely to have a PCP relationship and are much more likely to have received care at a retail clinic than their older peers.

For those of us old enough to remember the world of staff-model HMOs like Harvard Community Health Plan, this is precisely the dynamic that fueled the growth of the staff-model HMO (younger readers: a staff-model HMO brought PCPs, specialists, outpatient therapists, pharmacies and diagnostic equipment and services under one roof for patient convenience). The key question is whether younger workers will “outgrow” the less personal model of care in favor of deeper relationships with clinicians as they age or whether we’re witnessing a watershed moment in which care becomes more focused on cost and efficiency and less on intimate relationships with providers.

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