HSA Really Worth It In California?

[Shaka]

I've been considering switching over to an HSA offering at my company. California doesn't recognize HSAs, so there is additional work to calculate state taxes each year due to dividends and capital gains distributions.

I tried to do a comparison of my traditional plan vs. HSA (which I described in a previous post) can came up with the following result.

It assumes I have the same pool of money to invest no matter which plan I choose. Money left over from this pool after medical expenses goes into VTI (in either a post-tax account, the HSA account, or both) and grows for 27 years (my timeline for retirement). Plots shows money left over after liquidating the entire account at retirement and paying all state and federal taxes due (plots show doing this for both qualified expenses and unqualified expenses). California taxes over the 27 years are taken into account. I show three cases: a theoretical best case of no medical expenses at all, a theoretical worst case of maxing out your out of pocket expenses, and a case in the middle. The spreadsheet that performs these calculations can be viewed here.



For the assumptions shown here, the middle case nets about $80K to $120K more than using the traditional plan, as the inconvenience of paying California taxes. The spreadsheet allows one to select treasuries instead of a stock investment, but I haven't been able to figure out the proper growth vs. dividend assumptions, so I didn't show those plots here.

Any thoughts?

[anon_investor]

OP, your assumption is you will remain in California forever... will you?

[Shaka]

OP, your assumption is you will remain in California forever... will you?

No current plans to move, but who can predict the future?! =)

[Gleevec]

HSA in California are a fine option, personally I hold all my TIPS in my HSA to mitigate the state tax issue

[anon_investor]

OP, your assumption is you will remain in California forever... will you?

No current plans to move, but who can predict the future?! =)

That is something to bake into your analysis. If you were to leave California (and establish tax residence in another state) before HSA liquidation, then a tax efficient portfolio would not be subject to any california capital gains tax at liquidation.

For example a portfolio of a growth index ETF and an intermediate treasury ETF could work.

-a growth index ETF would have a lower dividend yield that the S&P500 or Total Stock Market index, would not kick off annual captial gains distributions, and long term would likely have very similar return to the S&P500/Total Stock Market Index.
-an intermediate treasury ETF would have state tax exempt dividends

Rebalance with new money as much as possible to avoid creating any taxable events. However, you can tax loss harvest if there is a large crash, which would allow you to rebalance without a tax consequence. Regular tax loss harvesting can also reduce the tax drag on the dividends.

If you already manage a taxable account, all these activities would not be much different. You might need to keep a spreadsheet and statements to prepare taxes since you will not get a nice 1099.

[Shaka]

HSA in California are a fine option, personally I hold all my TIPS in my HSA to mitigate the state tax issue

I'm trying to put this type of investment into my spreadsheet to compare the difference to equity investments. Do you know what the historical average annual growth rate of TIPS are? I'm new to investing and am not yet terribly familiar with this type of investment. I tried putting in some low growth assumptions and in certain cases an HSA comes out behind after-tax investments.

[Shaka]

If you already manage a taxable account, all these activities would not be much different. You might need to keep a spreadsheet and statements to prepare taxes since you will not get a nice 1099.

Yes, this is what I'm trying to determine...if the difference in choosing state tax exempt investments (that avoid this work) is worth the difference in growth from choosing investments that will require the spreadsheet work for CA taxes. =)

[willthrill81]

OP, your assumption is you will remain in California forever... will you?

That was the first thing that came to my mind as well. Millions have already left CA, so there's a good chance that the OP will at some point too.

[anon_investor]

If you already manage a taxable account, all these activities would not be much different. You might need to keep a spreadsheet and statements to prepare taxes since you will not get a nice 1099.

Yes, this is what I'm trying to determine...if the difference in choosing state tax exempt investments (that avoid this work) is worth the difference in growth from choosing investments that will require the spreadsheet work for CA taxes. =)

It is not a lot of work. The growth differential could be substantial.

[investing engineer]

California taxation on HSA is quite shaky, and can be exempted by the legislature at any point of time in the future. I won't give up the growth opportunity.

[Big Dog]

HSA in California are a fine option, personally I hold all my TIPS in my HSA to mitigate the state tax issue

I hold US Treasuries my HSA (and count that as part of the 'bond' portion of my AA).

[SB1234]

I've been considering switching over to an HSA offering at my company. California doesn't recognize HSAs, so there is additional work to calculate state taxes each year due to dividends and capital gains distributions.

I tried to do a comparison of my traditional plan vs. HSA (which I described in a previous post) can came up with the following result.

It assumes I have the same pool of money to invest no matter which plan I choose. Money left over from this pool after medical expenses goes into VTI (in either a post-tax account, the HSA account, or both) and grows for 27 years (my timeline for retirement). Plots shows money left over after liquidating the entire account at retirement and paying all state and federal taxes due (plots show doing this for both qualified expenses and unqualified expenses). California taxes over the 27 years are taken into account. I show three cases: a theoretical best case of no medical expenses at all, a theoretical worst case of maxing out your out of pocket expenses, and a case in the middle. The spreadsheet that performs these calculations can be viewed here.



For the assumptions shown here, the middle case nets about $80K to $120K more than using the traditional plan, as the inconvenience of paying California taxes. The spreadsheet allows one to select treasuries instead of a stock investment, but I haven't been able to figure out the proper growth vs. dividend assumptions, so I didn't show those plots here.

Any thoughts?

In my experience calculating taxes on HSA investments took less than 30 minutes. I saved more than 1500 on federal income taxes. For me the math is clear. It is worthwhile for me. VTI pretty much had zero cap gains distributions, So only pay taxes on dividends and interest income from the bond funds (I use 80/20 for HSA). Hopefully far in the future when I actually have to pay taxes on any cap gains I will probably lose 8% of the gains. But the federal taxes on the gains will still be zero.

[02nz]

In my experience calculating taxes on HSA investments took less than 30 minutes.

I use TurboTax, and the CA module flagged for me the need to enter capital gains and distributions from my HSA. I used my Fidelity HSA year-end statement, which had these amounts clearly listed. Total additional time for all this was maybe 3 minutes. The tax is very minimal if you didn't sell (use ETFs since they generally only have dividend distributions) and not a reason to avoid an HSA in CA.

[BroIceCream]

In my experience calculating taxes on HSA investments took less than 30 minutes.

I use TurboTax, and the CA module flagged for me the need to enter capital gains and distributions from my HSA. I used my Fidelity HSA year-end statement, which had these amounts clearly listed. Total additional time for all this was maybe 3 minutes. The tax is very minimal if you didn't sell (use ETFs since they generally only have dividend distributions) and not a reason to avoid an HSA in CA.

Agreed.
I use ITOT as the single position - low dividends and gains. I never sell, as I always have my "high deductible" max in cash. (My HSA is only 2% of my total portfolio, so adding a tax-free bond position is not interesting to me; I'll take all the growth I can get, after I set aside my 'deductible' aside in cash.)

To minimize tracking of each tax lot - I don't buy the ETF/fund with every payroll deduction (26x/year). Annually (Jan.1), I sweep the balance of my money market which is above my annual deductable into ITOT.... only one tax lot per year to track the basis of.

[Jtf6]

I literally did the same thing to calculate my dividends from fidelity using TurboTax. I put my money in to FZROX.

In my experience calculating taxes on HSA investments took less than 30 minutes.

I use TurboTax, and the CA module flagged for me the need to enter capital gains and distributions from my HSA. I used my Fidelity HSA year-end statement, which had these amounts clearly listed. Total additional time for all this was maybe 3 minutes. The tax is very minimal if you didn't sell (use ETFs since they generally only have dividend distributions) and not a reason to avoid an HSA in CA.

[02nz]

I literally did the same thing to calculate my dividends from fidelity using TurboTax. I put my money in to FZROX.

Note that FZROX does have some capital gains distributions, so slightly higher tax cost. But they appear to be pretty tiny so a very small difference vs say VTI.

[Shaka]

In my experience calculating taxes on HSA investments took less than 30 minutes.

I use TurboTax, and the CA module flagged for me the need to enter capital gains and distributions from my HSA. I used my Fidelity HSA year-end statement, which had these amounts clearly listed. Total additional time for all this was maybe 3 minutes. The tax is very minimal if you didn't sell (use ETFs since they generally only have dividend distributions) and not a reason to avoid an HSA in CA.

Agreed.
I use ITOT as the single position - low dividends and gains. I never sell, as I always have my "high deductible" max in cash. (My HSA is only 2% of my total portfolio, so adding a tax-free bond position is not interesting to me; I'll take all the growth I can get, after I set aside my 'deductible' aside in cash.)

To minimize tracking of each tax lot - I don't buy the ETF/fund with every payroll deduction (26x/year). Annually (Jan.1), I sweep the balance of my money market which is above my annual deductable into ITOT.... only one tax lot per year to track the basis of.

Thanks all for sharing these strategies. This has made me more comfortable. Regards!

[grabiner]

In my experience calculating taxes on HSA investments took less than 30 minutes.

I use TurboTax, and the CA module flagged for me the need to enter capital gains and distributions from my HSA. I used my Fidelity HSA year-end statement, which had these amounts clearly listed. Total additional time for all this was maybe 3 minutes. The tax is very minimal if you didn't sell (use ETFs since they generally only have dividend distributions) and not a reason to avoid an HSA in CA.

I don't remember TurboTax asking me to enter adjustments in NJ when I lived there; I had to know to make them, reporting bank interest and dividends that were NJ-taxable only. (I didn't have any capital gains in my HSA while a NJ resident.)

[Dennisl]

I have a question regarding TIPS bond funds in a HSA for california. Income from growth in principal and interest income are exempt from federal taxes. You have to pay california taxes on the capital gains. Where is the capital gains coming from if not the principal and/or interest? Why does that become taxable when a single TIPS bond held to maturity wouldn't be taxed at the state level? TIA

[tj]

I have a question regarding TIPS bond funds in a HSA for california. Income from growth in principal and interest income are exempt from federal taxes. You have to pay california taxes on the capital gains. Where is the capital gains coming from if not the principal and/or interest? Why does that become taxable when a single TIPS bond held to maturity wouldn't be taxed at the state level? TIA

If you sell a fund at a profit, that is a capital gain. The capital gain comes from your profit.

[Dennisl]

I have a question regarding TIPS bond funds in a HSA for california. Income from growth in principal and interest income are exempt from federal taxes. You have to pay california taxes on the capital gains. Where is the capital gains coming from if not the principal and/or interest? Why does that become taxable when a single TIPS bond held to maturity wouldn't be taxed at the state level? TIA

If you sell a fund at a profit, that is a capital gain. The capital gain comes from your profit.

So theoretically, I wouldn't have to worry about addressing state taxes until I sell? i.e as long as I buy and hold and sell purely for medical costs, I shouldn't have to worry about addressing state taxes if I'm hearing you correctly.

[tj]

I have a question regarding TIPS bond funds in a HSA for california. Income from growth in principal and interest income are exempt from federal taxes. You have to pay california taxes on the capital gains. Where is the capital gains coming from if not the principal and/or interest? Why does that become taxable when a single TIPS bond held to maturity wouldn't be taxed at the state level? TIA

If you sell a fund at a profit, that is a capital gain. The capital gain comes from your profit.

So theoretically, I wouldn't have to worry about addressing state taxes until I sell? i.e as long as I buy and hold and sell purely for medical costs, I shouldn't have to worry about addressing state taxes if I'm hearing you correctly.

Medical costs are irrelevant if the state doesn't recognize the HSA. You will pay state taxes on capital gains regardless of what you spend the money on.

[Afty]

AFAICT, my HSA provider HealthEquity doesn't help at all with the tracking you need to do for California taxes. So here's what I do:

1) I invest in only one fund in my HSA to minimize the amount of bookkeeping I need to do.
2) I don't withdraw from the investment portion, only from the cash portion. If I were to have a large medical expense, I would pay it out of my emergency fund and reimburse myself from the HSA once I've built up enough cash in it. This avoids having to calculate and pay capital gains tax on the HSA investment.
3) I invest in a tax-efficient investment in my HSA. For me, that's a Total Stock Market Index Fund. It pays dividends, but they are small and I'm only paying CA tax (not Federal) on them.

I think it's worth the minor hassle given that I'm saving a bunch on Federal taxes.

[JediMisty]

HSA in California are a fine option, personally I hold all my TIPS in my HSA to mitigate the state tax issue

I hold US Treasuries my HSA (and count that as part of the 'bond' portion of my AA).

+1. I reside in the other state that doesn't recognize HSAs. BTW, I get taxed at my state for employer contributions to my HSAs as well.

[Big Dog]

I have a question regarding TIPS bond funds in a HSA for california. Income from growth in principal and interest income are exempt from federal taxes. You have to pay california taxes on the capital gains. Where is the capital gains coming from if not the principal and/or interest? Why does that become taxable when a single TIPS bond held to maturity wouldn't be taxed at the state level? TIA

If you sell a fund at a profit, that is a capital gain. The capital gain comes from your profit.

So theoretically, I wouldn't have to worry about addressing state taxes until I sell? i.e as long as I buy and hold and sell purely for medical costs, I shouldn't have to worry about addressing state taxes if I'm hearing you correctly.

Uh, not necessarily. If the HSA account pays out a capital gain, CA requires you to report it each year, and you must do this manually as an adjustment to CA-540.

I use Fido's FUAMX, Intermediate Treasury Bond Index for my CA HSA. It paid a cap gain of one cent this year, and prior to that, its last cap gain was in 2016, so annual paperwork is not too onerous.

[grabiner]

I have a question regarding TIPS bond funds in a HSA for california. Income from growth in principal and interest income are exempt from federal taxes. You have to pay california taxes on the capital gains. Where is the capital gains coming from if not the principal and/or interest? Why does that become taxable when a single TIPS bond held to maturity wouldn't be taxed at the state level? TIA

Bond funds don't necessarily hold their bonds to maturity. If a fund sells a bond before maturity, it may have a capital gain, which it must distribute to the shareholders. In CA, capital gains distributed by TIPS funds are taxable. (In NJ, they are not, as long as the fund is considered a "qualified investment fund.")

In addition, even if the fund doesn't distribute any capital gains itself, its share price will change as bond prices change. When you sell the fund, you may have a capital gain or loss.

However, all of these costs should be small. TIPS report both the coupon and the inflation adjustment as distributions. Therefore, if you buy an individual TIPS and hold it to maturity, you will get back the inflation-adjusted principal, but you have already paid federal tax on the adjustment, and thus have no capital gain. Capital gains will result only from changes in yields, or from fund dividends which have been earned but not yet been paid out. (Most bond funds accrue dividends daily, but most TIPS funds do not. If you hold a fund on the day before the distribution, you receive the full distribution, and the fund price declines by an equal amount if the market doesn't move.)

[mauwong]

......... TIPS report both the coupon and the inflation adjustment as distributions. Therefore, if you buy an individual TIPS and hold it to maturity, you will get back the inflation-adjusted principal, but you have already paid federal tax on the adjustment, and thus have no capital gain. Capital gains will result only from changes in yields, or from fund dividends which have been earned but not yet been paid out. (Most bond funds accrue dividends daily, but most TIPS funds do not. If you hold a fund on the day before the distribution, you receive the full distribution, and the fund price declines by an equal amount if the market doesn't move.)

Just a quick question:

Is there a state tax on TIPS' inflation-adjusted principal? In essence, could I buy newly issued individual TIPS (similar to Treasuries) in HSA, hold them to maturity, and don't have to worry about tracking for CA state tax?

Update: Found out the answer from another poster (thanks, mervynj7) that TIPS' inflation-adjusted principal is not taxable at state or local level.