HSAs: A new kind of free lunch

Nobel laureate and renowned economist Harry Markowitz famously called diversification the only free lunch in finance. That was before the introduction of health savings accounts (HSAs).

A new white paper from the Empower Institute, “The New Rx for Retirement,” demonstrates that, used wisely, HSAs can help employees gain thousands more dollars in retirement than they could generate from retirement plans alone, with no added risk. Employers who provide the plans can reap sizable cost and tax savings, with little if any downside. I wonder what Markowitz would make of HSAs.

Save money, gain flexibility

HSAs are available to employees enrolled in qualified high-deductible healthcare plans (HDHPs). The accounts are becoming increasingly common: More than 21 million employees held an HSA as of June 2017, up 16% from the previous year.1

Yet HSAs are still underused given the benefits they offer. The accounts are triple-tax-free: Contributions come out of pretax income, investment earnings aren’t taxed, and withdrawals for qualified expenses aren’t taxed either.2

What’s more, HSAs increase employees’ financial flexibility. Money invested in an HSA can be withdrawn to pay for out-of-pocket healthcare expenses at any time or left in the account. If a balance remains at the end of the year, it rolls over for future use and can stay invested. Another plus: Beginning at age 65, account holders can withdraw funds for any reason without penalties or fees. If a withdrawal isn’t for healthcare, the account holder will just pay income tax on it.

Employers win too

The benefits HSAs offer employers are less obvious but may be equally powerful. First, as more employees enroll in HSAs, more money will be exempt from the employer’s portion of FICA. Over time, that exemption can add up to big savings.

Second, data from Optum Bank, the leading HSA provider in the country, finds that participants who use HSAs as a long-term financial planning tool come to consume healthcare more efficiently. The research suggests HSAs produce a greater awareness of healthcare costs and a more conscientious use of healthcare: As HSA holders accumulate money in their accounts and see it grow, they tend to embrace preventive care and make fewer out-of-network visits.

How to eat a free lunch

Some employees may have account fatigue that leads to confusion about yet another savings option and how much they should save in each type of account.

The Empower Institute ran the numbers and came up with a simple formula for figuring out what money to put in which account. Here’s what the research found:

Employees at nearly all tax rates should consider contributing first to their retirement plan up to the limit of the company match. Additional savings dollars should go in the HSA up to the annual limit, and any remaining dollars should go to the retirement plan up to the annual contribution cap. For more details on this, don’t forget to read the white paper.

Here’s one example of how this strategy would work. Say an employee has an annual salary of $80,000 and is currently saving 8% of their pretax earnings, or $6,400 annually. Their employer offers a 50% match on the first 6% of salary.

Retirement contribution: $4,800 (maximizes match)
HSA contribution: $1,733
Total savings contribution: $6,533
Thanks to the FICA exemption on HSA contributions, the employee in this scenario can actually save more — without affecting their take-home pay — than if they were only contributing to a retirement account.

The bottom line: Employer matches remain one of the best deals around for employees saving for retirement, but HSAs provide more bang for the buck than unmatched money in a workplace retirement plan.

The HSA impact

Empower’s research also delved into the potential long-term impact of HSAs for participants. It found that for many employees, using an HSA in addition to a retirement plan can add many thousands of dollars in purchasing power without affecting take-home pay. How many thousands of dollars depends on each employee’s income, savings rate and years until retirement as well as other factors.

The effect can be enormous. In one scenario, an employee who is 25 years from retirement and saves 10% of their income would gain $81,000 by retirement as a result of directing a portion of their savings to an HSA.3 That’s a lot of lunches — all made possible by the smart use of a health savings account.

Source: Ken Forsythe, Empower Institute, “The New Rx for Retirement,” June 2018.