Good HSA Investing Can Let You Retire Early


If you are fortunate enough to have a Health Savings Account, or HSA, you might be able to retire earlier than a lot of your peers.  Many people have the money to retire by their late fifties, but they hold out a few more years because they’re worried about losing their health insurance before they become eligible for Medicare.  If you invest properly in an HSA starting when you’re young, you might have the cash needed to carry you through to the time you’re eligible for Medicare and beyond, allowing you to retire on your timetable.

This is even assuming Medicare will still be there when you’re ready to retire.  The actuaries for Medicare have been warning for years that the system is running out of money and will either need an infusion from Congress/taxpayers or it will need to start cutting benefits.  This makes even the more reason to beef up your HSA.

So let’s look at the basics of an HSA and then talk about how to contribute and invest in an HSA to have the money you’ll need for medical expenses later in life.

What is an HSA?

A Health Savings Account, or HSA, is a private account that you can use for medical expenses, including paying the doctor, paying for labs and x-rays, and paying for prescription drugs.  You can also use an HSA to pay for COBRA continuation of insurance if you lose a job.  This means that if you are laid off or see your hours drastically cut, you can continue to get the same healthcare insurance for a period of time (currently 18 months, but always check this since it can change) so long as you are willing to pay both your part and the portion your employer was paying before.  So, having a well-funded HSA can help protect you from an unexpected job loss even years before you retire by providing the money needed to pay for COBRA coverage.  Unfortunately, it cannot (at this time) be used to pay for private insurance.

When you use your HSA to pay for qualified medical expenses (things like those listed above), you don’t need to pay taxes on the withdrawals from the HSA.  If you buy other things, you may need to pay some taxes.

Who can start an HSA?

Basically you can start an HSA if you have an employer who provides one, which means that your employer offers a high-deductible health insurance plan option.  The idea is to encourage employees to choose a plan with a high deductible by also having an account from which they can pay for expenses before meeting their deductible.

How does an HSA get funded?

Many employers fund part of the HSA for you as further incentive to choose the option.   In addition, you are able to contribute some of your own money from your paycheck to fund the HSA.  There are limits on how much you can contribute, so check the laws before proceeding.

Why would you want to contribute to an HSA?

If you pay for medical expenses out-of-pocket, you’ll be spending money on which you will have already paid taxes.  You can deduct medical expenses from your taxes, but only above a really high threshold that most people do not meet.  If you instead put the money into an HSA, then pay for medical expenses out of the HSA, you will not pay taxes on the money deposited from the first dollar.  So, if you are in the 15% tax bracket, this is like the government paying for 15% of your medical bills.  In fact, you don’t have to spend the money on medical bills during the year in which you make the contributions to see the savings.  As soon as you put the money into your HSA, you can deduct the contribution from your taxes, while letting the money stay in the HSA until you need it.

Why would you want to invest in an HSA?

In addition not paying taxes on the money you put in, money from interest or capital gains earned inside of the HSA will be tax-free if used on qualified medical expenses.  This means that you can put $2,000 in an HSA today, invest it in stock mutual funds for 20 years, and maybe then have $16,000 or so that you can spend on medical expenses, all tax-free.  Put in $10,000 today and you might have $80,000 later, and so on.  That $10,000 invested in your early twenties for 40 years might provide around $650,000 in your early sixties, which is enough to pay for some significant medical events even without insurance.  Double the amount you contribute and you’ll have over a million dollars available.

And that’s the part that might help you retire early.  If you have enough saved up in an account to self-insure for the unlikely event that you’ll have a major medical event during the three or four years between retirement and Medicare, you may be able to take the risk.  If before you retire the requirement in the Affordable Care Act is repealed that prevents the sale of catastrophic, major medical insurance , that would be even better since then you could buy inexpensive insurance to pay for the unlikely event that a major surgery will be needed and just self-insure for the more minor events.   The nice part about investing money for medical expenses in an HSA instead of just putting money into an IRA for retirement is that you can spend it tax-free on medical expenses before retirement age.  This provides protection and options for you that an IRA will not.

How should you invest the money inside an HSA?

In investing, you need to look at how soon you’ll need the money.  Money you’ll need (or have a reasonable chance of needing) within the next three years or so should be kept in cash.  Money that may be needed in 3-10 years you should be invested in a mix of stocks and bonds.  The higher the percentage of bonds (up to 80%), the more stable your account balance will be but the lower your return.  Money you don’t need for ten, fifteen, or twenty years or more should probably be invested almost entirely in stocks since they’ll offer the best return and protect your money from inflation.

Cash:  So first look at your deductible and multiply by three to estimate how much money you may need to pay out-of-pocket for medical expenses in the next three years.  Then look at your income and free cash flow and decide how much of those expenses you could cover from your paychecks if needed.  Plan to keep the amount beyond what you could cover from your income in cash so that you’ll be ready for near-term medical needs.  For example, if you have a $5,000 deductible and plan to cover $2500 per year from your salary, you’d need to keep 3 x $2500 = $7500 in cash inside the HSA.  For the first couple of years after you open the HSA, you’ll probably just be building up cash.  Investing comes a little later.

Bonds/fixed income assets: Figure out next what your deductible will be for seven years.  When doing this, assume that your deductible will increase by 10% each year for each of those seven years.  For example, if you have a $5,000 deductible now, use that value for the first year, then multiply by 1.1 for each year afterwards to get $5,500, $6050, $6655, $7320, $8052, and $8858, for a total of about $47,500 over the seven-year period.   Plan to keep about half this amount in bonds and the other half in stocks.  This will result in that portion of your portfolio being fairly stable in value while enjoying modest growth.  In years when the market really falls like 2008, this portion of your account may fall about 15% while the stock market as a whole falls 40%.  In years like 2009 when stocks go up 30%, this portion of your portfolio might gain 15-20%.  This will nearly ensure that you’ll be able to generate the cash you’ll need to meet your deductible in the period 3-10 years from now.

For the first ten years or so after you start an HSA,  you’ll probably not have this much to invest.  Just start by building up the amount of cash you’ll need from the section above,  Once you’ve got enough cash, start buying half bonds and income funds/half stocks and growth funds as you contribute more money.  As far as selecting particular funds goes, you’ll want to just buy an income fund that buys the whole market –  all types of bonds and some dividend paying stocks if possible.  For the stock portion, split between funds that invest in large and small caps 50/50 or just buy a whole market stock fund.  When choosing funds, get the ones with the lowest fees you can find.  If you can find passive funds – those that invest based on a strategy rather than hiring managers to choose investments – that is normally the lowest-cost option.

Stocks/growth assets:  Once you’ve invested enough to cover yourself for ten years out, you’re ready to invest any additional funds for long-term growth.  Here you’ll want to buy a mixture of large cap and small cap stocks, while skewing slightly towards small caps.  For example, you could put 40% in a large growth stock fund and 60% in a small growth stock fund.  If you have the option to buy into an REIT fund, which invests in real estate, you could add this to the mix with maybe a 20% REIT, 50% small cap, 30% large cap allocation.

As with everything, this will start slow with only a small amount invested in your HSA.  After sticking to the plan for many years, however, suddenly the value will explode.  You’ll be surprised at how much money your investments are generating and how easy it is to cover your deductible and medical expenses each year.  Before you know it, you’ll have plenty of money to cover medical expenses.  You’ll then have a lot more freedom and a lot more options.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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