HSA Strategy (Part 5)

In Part 4, I discussed some different approaches to managing [investment] funds in Health Savings Accounts (HSA). I conclude today by addressing one other question: should the HSA be approached as a portfolio in and of itself or may it be used as one segment of the total portfolio?

Please see the second paragraph of Part 4 for the full disclaimer.

If I’m going to invest a segment of my overall portfolio to invest in individual stocks, then perhaps I want to do that in my HSA where the Triple Tax Advantage (see numbered list) provides most value. This would be great unless one of the stocks ends up a BetterInvesting® “Rule of Five” loser (see The 80% Rule”) thereby sapping the HSA forevermore since contributions are limited. Of course, it could be a “Rule of Five” winner and the latter [uncapped] potential benefit outweighs the former risk.

Treating the HSA as its own diversified portfolio can eliminate the risk of catastrophic loss but I see several disadvantages.

The first disadvantage, as alluded to above, is inefficient asset location. Maximize HSA tax-free compounding by allocating to high-growth equities and move low-growth assets (e.g. bonds) to a Traditional IRA or 401(k) where growth eventually gets taxed as ordinary income.

A second disadvantage is potential fatigue due to management complexity. If aiming to maintain a particular 60/40 or 70/30 equity/bonds split, then manual rebalancing trades will have to be done periodically for what is probably an individual’s smallest account. For those living in CA or NJ where the HSA’s tax-exempt status is not recognized, things get worse because rebalancing can trigger state capital gains taxes. Every dividend must also be tracked for state tax reporting.

A third disadvantage results from many HSA providers offering limited investment options. Many providers also require keeping at least $1,000–$2,000 cash in the account to invest [although a diversified portfolio may include this anyway].

Treating the HSA as a separate portfolio also makes it harder to monitor overall risk exposure. Being conservative in an HSA but aggressive in a 401(k) may result in an overall allocation that doesn’t actually match one’s risk appetite.

Inflation risk is a fifth potential disadvantage: returns on cash and/or bonds not outpacing rising medical costs.

In summary, treating an HSA as a standalone portfolio creates tax friction and management complexity that can erode long-term wealth. The better option seems to be inclusion with the high-growth segment of an overall diversified portfolio.