A Less Outrageous Way to Optimize Your HSA

How you feel when someone asks how you’re optimizing your HSA for maximum growth and lowest tax liability

So most PF or FIRE advice around a Health Savings Account (HSA) optimization goes something like this:

  1. Make the maximum HSA contribution for the tax year (e.g. $3,550 individual or $7,100 family in 2020) and front-load the contribution if you can
  2. Invest that contribution into low-fee funds, ideally a highly-diversified index fund or a fund that that might generate lots of short-term gains or dividends for tax optimization
  3. When qualified medical expenses are incurred, DON’T USE THE HSA, but rather cash-flow those costs and keep the receipts; THEN
  4. Let the beautiful magic of compounding and historic market growth do its thing until you hit the age of 65 when you can then withdrawal the funds as ordinary taxable income à la Traditional IRA; OR
  5. Withdraw the funds before 65 when an investment opportunity arises that would beat the historic, broad market growth of 8% (or, ya know, an emergency) using the receipts you diligently saved before to reimburse yourself for those qualified medical costs incurred many years or perhaps decades prior

Assuming you have the cash flow to cover those medical expenses, this approach is the mathematically correct answer and all things being equal, the logic is sound… but given our nature and fallibility as human beings, I have a couple concerns with this approach.

One, the future is basically unpredictable, especially when it comes to humans, and specifically so when it comes to matters of policy. We have no idea how tax policy and healthcare will change over the years. Will fat HSA balances be subject to a new tax? Will the IRS adopt a use-it-or-lose-it approach for qualified expenses? Will the definition of a qualified expense get narrower? Who knows.

Two, and let’s get a little morbid for second, what if you die or become mentally impaired for some reason? Do you want to leave your family with the burden of figuring this out? Or not, and effectively leave money on the table with the IRS? I think it’s a fair generalization that us PF/FIRE types love our spreadsheets and detailed, quasi-algorithmic plans, but what about the person we marry or the kids we raise? They may not think like us and I’d rather not dump this beautifully complex burden on them.

So what do I do instead?

Try to strike a better balance between math and human behavior.

  1. Make the maximum annual contribution to my HSA; this comes through payroll deduction for me, so no front-loading 😢
  2. Keep no more cash than my annual deductible amount in the HSA deposit account and invest anything beyond that in low-fee, broadly-diversified index funds or REITs
    #Protip: if your employer-sponsored HSA custodian is fee-heavy or offers no/poor investment options like mine, consider opening an HSA with Fidelity and making in-service transfers from the sad-panda HSA 🐼 over to Fidelity’s no-fee HSA 🙌
  3. And here’s the difference! As medical expenses are incurred, I cash-flow them, but simultaneously withdraw the funds from the HSA and invest them into regular, non-tax advantaged brokerage account (VTSAX FTW!); THEN
  4. Let the beautiful magic of compounding and historic market growth do its thing until an another investment opportunity occurs or retirement or… well, whenever I want for whatever reason, no penalties 😁

What do I give up with this approach? Assuming nothing changes, I’ll miss out on tax-free gains, and gains on gains, and gains on gains on gains ad infinitum over the years or decades as those HSA dollars have lost their cool tax-advantaged name-tag. Boo-hoo… that’s the opportunity cost of keeping life a little simpler. What I gained is more important to me. Namely, I get rid of the need to keep track of receipts for decades worth of medical expenses to be reimbursed ad-hoc or post age 65, won’t leave my family with the burden to figure this all out if I’m mentally-impaired or die prematurely, and dodge any policy changes to HSAs.

So that’s how I approach HSA optimization. How about you? Disagree? Have other interesting approaches? I’d love to hear them. Let me know in the comments or tweet @totesoutraged.