Are you making this major HSA mistake?

If you have a health savings account (HSA), there's a good chance you're not flexing its full financial muscle, since research shows that only 5% of HSA holders are using one of the account's most powerful features.

An HSA has three tax benefits: Contributions are made with tax-free money, withdrawals to cover qualified expenses aren't taxed, and HSA investments grow tax-free. It's this last tax perk that's sorely underused, with a study by the nonprofit Employee Benefit Research Institute (EBRI) concluding that 95% of HSA accounts contain only cash balances and no investments..

Cash interest rates in HSAs vary from a fraction of a percent point to about 2%. Bank of America pays 0.1% to 0.45%, depending on your balance. Fidelity pays 0.82% on FDIC-insured deposits and 1.33% on money market balances. Even at the high end, these cash interest rates aren't going to offset inflation, which has been running at about 2% for the past two years. By comparison, the long-term, inflation-adjusted return in the stock market is 7%.

Despite the clear opportunity for higher earnings, investing your HSA contributions isn't quite a no-brainer. There is risk, because investing those funds gives you less flexibility to take tax-free withdrawals for your current healthcare expenses. You can always sell your investments if you need the money. But if you're caught in a market dip, you may not want to lock in those losses. Here are three strategies to manage that risk.

1. Have a plan for current medical expenses

You have an HSA because you're enrolled in a high deductible health plan. That means your 2020 healthcare deductible is, at a minimum, $1,400 for you individually or $2,800 for your family. Before you invest 100% of your HSA balance, consider how you'd cover these expenses should you face a major healthcare issue.

It's wise to hold back enough cash in your HSA to cover your deductible. Once you reach that balance, you can start investing any additional contributions. This way, the cash portion of your HSA functions like a specialized arm of your emergency fund -- with tax perks to boot.

And speaking of that emergency fund, make sure you have enough on hand to cover three to six months of your living expenses. Unexpected injuries and illnesses can lead to more than just pricey doctor visits; you might lose out on income if you can't work. If you do get sick or injured and it keeps you out of the office, you'll be glad you set that money aside.

2. Consider your other retirement accounts

While the cash in your HSA acts as an extension of your emergency fund, the investment portion is an extension of your retirement portfolio. When choosing your HSA investments, consider how they'll fit in with your overall retirement strategy. Your picks should conform to the same asset allocation you'd follow in an 401(k) and IRA for the mix of stocks, bonds, and other instruments.

If you don't have an allocation strategy, a good starting point is the rule of 100: Subtract your age from 100, and the result is the percentage of your portfolio to hold in equities. When you're 40 years old, for example, the rule of 100 says your portfolio should consist of 60% equities and 40% bonds. Know that this rule has its critics, who say it's too conservative. So adjust the percentage to suit your situation and risk tolerance. A higher percentage of equities and equity funds will create more opportunity for growth, while a higher percentage of bonds and bond funds will add stability.

On the subject growth, you may wonder what happens if your HSA balance grows to more than you'll need for medical expenses. That's unlikely for two reasons. First, there are annual contribution limits: $3,550 for individuals and $7,100 for families in 2020. If you're 55 or older, you can also make $1,000 in catch-up contributions. Second, even if you contributed the maximum for 20 years, the balance won't exceed your predicted healthcare expenses in retirement -- which some sources estimate at nearly $400,000.

Plus, once you turn 65, you can use your HSA funds for any type of expenses. Those distributions will be taxable at your normal income tax rate, just like your 401(k) and traditional IRA contributions.

3. Choose diversified, low-cost funds

You can usually invest HSA contributions in mutual funds, exchange-traded funds (ETFs), stocks, and bonds. The simplest approach is to rely on mutual funds and ETFs with low expense ratios, which represent the amount shareholders get charged annually for the fund's operating costs. This is a key indicator of future success. Funds also have the advantage of being diversified, which makes them less volatile than shares of stock in a single company.

Mutual funds and ETFs are fairly liquid, meaning you can sell them quickly if you need to raise some cash. Look for funds from well-known families, and stick with categories you recognize like S&P 500 index funds and large-cap equity funds. Avoid specialty ETFs that invest in things like hedge funds and commodities. These are likely to be more volatile.

Increase your tax-free earnings growth

Investing your HSA contributions maximizes wealth building in your tax-advantaged retirement accounts. As long as you have a plan for covering your current healthcare expenses, it's smart to take a long-term strategy in your HSA. You'll be stronger financially for it.

 

This article was written by Catherine Brock from The Motley Fool and was legally licensed through the NewsCred publisher network. Please direct all licensing questions to legal@newscred.com.