HSA with state tax considerations - how to invest?

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Nohbdy
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HSA with state tax considerations - how to invest?

Post by Nohbdy »

Hello. I’m hoping to get some additional insight regarding HSA investing.

I am in California so contributions and investment returns are currently fully taxed as income for state. We file MFJ - 9.3% state tax (marginal) rate. I expect we might land in 8% state tax once I’m retired in 8 years or so. We spend about half of the max HSA contribution each year as we go. The other half is invested.

Currently HSA is 100% VWENX - wellington admiral .16

The following bond fund seems to offer CA tax free option:
PRRIX - PIMCO real return .47

Other bond funds which I am not sure whether I would pay CA or not:

VSGDX - short federal fund admiral .10
PDMIX - PIMCO GNMA .51
DODIX - Dodge & Cox income .42
LHYOX - Lord Abbet high yield .61

There are also a variety of target date funds, balanced funds, stock funds, a REIT…

I noticed that PRRIX and PDMIX are somewhat uncorrelated historically so I don’t hate the idea of holding those as balancing partners.

I’ve been puzzling at this weighing: 50/50 PRRIX/PDMIX VS S&P index fund VS wellington. My quandary is regarding the optimal choice here, given that I do hold bonds in tax deferred accounts (sep and 401k) which I could use to rebalance against. Is the tax benefit of holding govt bonds in the HSA enough to justify the high ER on those active bond funds, and also sufficient to offset the potential additional income I might eventually see in my tax deferred by holding more stocks there?

What else am I not considering?

Thanks for any thoughts/advice. This one has too many moving parts for me to wrap my head all the way around it.
Last edited by Nohbdy on Thu Jan 13, 2022 12:46 pm, edited 1 time in total.
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grabiner
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Re: HSA with state tax considerations - how to invest?

Post by grabiner »

PIMCO Real Return is only partly exempt from state tax, and none of the others are. CA exempts only Treasury bonds, not other government bonds such as FNMAs (which are held in Short-Term Federal) and GNMAs. A fund gets no exemption unless at least 50% of its assets are Treasuries. PIMCO Real Return holds Treasuries and TIPS, but it also holds a lot of derivatives, which are taxable; you'll have to check with PIMCO how much of the income is exempt from state tax.

I would suggest holding a Treasury fund or a plain TIPS fund such as Vanguard's fund or the ETFS VTIP (short), TIP (intermediate), LTPZ (long). If your own HSA provider doesn't offer a good fund, you can switch HSA providers.

And it does make sense to have one asset allocation across all your accounts. If your HSA is all bonds, you can move an equal amount from bonds to stock in your 401(k) to keep the same overall allocation.

The other reason to hold bonds in the HSA is that you avoid most of the capital gain. CA does tax capital gains on bond funds, even on Treasury bonds, but the gains on such funds will be relatively small.
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Nohbdy
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Re: HSA with state tax considerations - how to invest?

Post by Nohbdy »

grabiner wrote: Wed Jan 12, 2022 9:51 pm PIMCO Real Return is only partly exempt from state tax, and none of the others are. CA exempts only Treasury bonds, not other government bonds such as FNMAs (which are held in Short-Term Federal) and GNMAs. A fund gets no exemption unless at least 50% of its assets are Treasuries. PIMCO Real Return holds Treasuries and TIPS, but it also holds a lot of derivatives, which are taxable; you'll have to check with PIMCO how much of the income is exempt from state tax.

I would suggest holding a Treasury fund or a plain TIPS fund such as Vanguard's fund or the ETFS VTIP (short), TIP (intermediate), LTPZ (long). If your own HSA provider doesn't offer a good fund, you can switch HSA providers.

And it does make sense to have one asset allocation across all your accounts. If your HSA is all bonds, you can move an equal amount from bonds to stock in your 401(k) to keep the same overall allocation.

The other reason to hold bonds in the HSA is that you avoid most of the capital gain. CA does tax capital gains on bond funds, even on Treasury bonds, but the gains on such funds will be relatively small.
Thanks I really appreciate your insights and the clarification re: gnma especially.

This is the HSA that my employer offered. They have very limited bond offerings, which are all listed above.

Maybe I can pull the invested portion over to my brokerage. I’ll look into it.

If a fund is over 50% treasury bonds then is all of the income tax free, or just the income that is from the treasuries?
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Re: HSA with state tax considerations - how to invest?

Post by grabiner »

Nohbdy wrote: Wed Jan 12, 2022 10:18 pm This is the HSA that my employer offered. They have very limited bond offerings, which are all listed above.

Maybe I can pull the invested portion over to my brokerage. I’ll look into it.
You can roll an HSA to another HSA provider, just as you can do with an IRA. So you may not be able to roll it to your own brokerage, but Fidelity is popular with Bogleheads. At Fidelity, you can buy Fidelity funds, or any ETFs.
If a fund is over 50% treasury bonds then is all of the income tax free, or just the income that is from the treasuries?
Just the income from Treasuries. This will be almost all the income for a true Treasury fund, but it is relevant for something like Vanguard Intermediate-Term Bond Index, which is more than half Treasuries but holds some corporate bonds. (Total Bond Market is less than half Treasuries and thus gets no CA tax exemption.)
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Re: HSA with state tax considerations - how to invest?

Post by w5000 »

I'd pose the question of why you want to hold bonds in your HSA at all? The HSA is a special account that you can use to pay for qualified medical expenses without paying any federal tax on that pre-tax money, so seems like you'd want it to grow as much as possible. That's the typical BH strategy for HSAs -- pay for qualified medical expenses out of pocket, and leave all the money in the HSA to let it grow tax-free. (You can reimburse yourself for your qualified medical expenses whenever you want, say 30 years from now.) But if you don't have the cash to do that, still makes sense to let the invested portion of your HSA grow as much as possible.

And even if you do have to pay 8% CA tax on capital gains and investment distributions, this still seems like a good deal and thus a valid strategy.

In a sense, this seems similar to the concept of asset allocation regarding Roth accounts -- since there won't be any more taxes on Roth funds, you want them to grow as much as possible, so typically you'd hold 100% stocks in your Roth, at least until close to the time when you need to draw down on those funds.

All subject to your overall asset allocation of course, but I think most people have enough room in their 401(k) or similar to hold as much bonds as they want.
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Nohbdy
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Re: HSA with state tax considerations - how to invest?

Post by Nohbdy »

w5000 wrote: Thu Jan 13, 2022 8:29 am I'd pose the question of why you want to hold bonds in your HSA at all? The HSA is a special account that you can use to pay for qualified medical expenses without paying any federal tax on that pre-tax money, so seems like you'd want it to grow as much as possible. That's the typical BH strategy for HSAs -- pay for qualified medical expenses out of pocket, and leave all the money in the HSA to let it grow tax-free. (You can reimburse yourself for your qualified medical expenses whenever you want, say 30 years from now.) But if you don't have the cash to do that, still makes sense to let the invested portion of your HSA grow as much as possible.

And even if you do have to pay 8% CA tax on capital gains and investment distributions, this still seems like a good deal and thus a valid strategy.

In a sense, this seems similar to the concept of asset allocation regarding Roth accounts -- since there won't be any more taxes on Roth funds, you want them to grow as much as possible, so typically you'd hold 100% stocks in your Roth, at least until close to the time when you need to draw down on those funds.

All subject to your overall asset allocation of course, but I think most people have enough room in their 401(k) or similar to hold as much bonds as they want.
I want to hold bonds in HSA because I have an 8-9% tax incentive (on the gains) to do so. If I hold the same bonds in a tax deferred account, then I will be paying state tax at some point. I also think that the HSA can be thought of as a spending account, like a part of my emergency fund for medical. Indexing to inflation seems to be sensible, to me at least. Those are both good reasons I think to hold government bonds there.

However, I also do want to hold stocks in the HSA for the reasons that you mention. Those are good reasons too. I am not saying one is better than the other. I am asking: which is optimal? I suspect that there might be a break even point on the gains here meaning: if stocks outperform govt bonds by X then the fed tax advantage outweighs the state tax.

We pay smaller expenses and copays out of the HSA as we go, and collect receipts for anything over $500 that we will pay ourselves back on later. We do have room in tax deferred for more bonds.

I edited the original post to reflect comments addressing which funds might be eligible for state tax exemption.
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Re: HSA with state tax considerations - how to invest?

Post by nalor511 »

Fidelity tracks your dividends, just invest however you want, and report the divs on your CA 540 sch CA
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Re: HSA with state tax considerations - how to invest?

Post by Artsdoctor »

It sounds as if you're already spending 1/2 of the annual contributions to the HSA(s). Can you clarify the reasoning behind that? Is it because you want to or because you have to? If you're spending it and not investing it, would that imply that if you had higher medical expenses this year or next year you'd be compelled to take the funds from the HSA? If so, then is using the HSA as an investment account the best thing to do?

If you think there's a small but real chance that you'll need the funds in the HSA in the near future because unanticipated medical expense, then put the money in treasuries and forget about the tax (you'll owe nothing). Your current investment options are limited but there's nothing that is stopping you from transferring the money to another HSA outside of your work-sanctioned HSA.
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Nohbdy
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Re: HSA with state tax considerations - how to invest?

Post by Nohbdy »

Artsdoctor wrote: Thu Jan 13, 2022 6:11 pm It sounds as if you're already spending 1/2 of the annual contributions to the HSA(s). Can you clarify the reasoning behind that? Is it because you want to or because you have to? If you're spending it and not investing it, would that imply that if you had higher medical expenses this year or next year you'd be compelled to take the funds from the HSA? If so, then is using the HSA as an investment account the best thing to do?

If you think there's a small but real chance that you'll need the funds in the HSA in the near future because unanticipated medical expense, then put the money in treasuries and forget about the tax (you'll owe nothing). Your current investment options are limited but there's nothing that is stopping you from transferring the money to another HSA outside of your work-sanctioned HSA.
Sure, thanks for taking an interest.

We usually spend at or near the out of pocket max for our insurance on HSA eligible expenses, which is $6k. A vast majority of those expenses are single or double digit dollars which we pay out of the HSA directly. If it is hundreds of dollars on a single receipt then we evaluate our funds and most of the time we come out of pocket and save that receipt to reimburse ourselves later. Our organizational skills are ok, but I’m hesitant to add a ton of complexity for the diminishing return per effort involved that collecting dozens of receipts might create. I think we would lose receipts if we tried to do too much.

The small but real chance of needing HSA sooner would involve me losing my job which I have had for over 2 decades. It is not zero, but it is not keeping me up at night.
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Re: HSA with state tax considerations - how to invest?

Post by Artsdoctor »

I think there are many people who would chafe at the concept of having to keep a lot of receipts so you're not alone.

Perhaps my questions revolve around how much you'd actually need access to your HSA funds. In order to qualify for an HSA, you'd need a high-deductible plan. Often, although not always, the out-of-pocket expenses of these plans can be substantial by the time you fulfill your deductibles and co-pays. For example, you might have a plan with a $1,500 deductible but by the time you get through the family's co-pays, your total out-of-pocket expenses might be $7,500 or more. Every plan is different. So my questions for you basically revolve around a single question: if you had significant medical expenses for an unexpected illness that caused you to shell out all of the money to meet your family deductible and all of the co-pays, would you need to spend out of your HSA or would be able to find the money elsewhere (cash account, for example).

If you would not be able to meet those financial needs by paying from another account, then I would propose that you invest the money in the HSA conservatively (perhaps with treasuries). If you're able to invest the money in equities because you are confident you wouldn't need it for years, then investing in a tax-efficient equity index fund could be an option for you although it would require some bookkeeping that you may not be interested in (your state capital gain/loss tally might be different than your federal tally, you'd have to declare your dividends annually, and you'd have to declare any capital gains when selling your funds if you're still living in California at the time).
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Re: HSA with state tax considerations - how to invest?

Post by wetgear »

Nohbdy wrote: Wed Jan 12, 2022 5:35 pm Hello. I’m hoping to get some additional insight regarding HSA investing.

I am in California so contributions and investment returns are currently fully taxed as income for state. We file MFJ - 9.3% state tax (marginal) rate. I expect we might land in 8% state tax once I’m retired in 8 years or so. We spend about half of the max HSA contribution each year as we go. The other half is invested.

Currently HSA is 100% VWENX - wellington admiral .16

The following bond fund seems to offer CA tax free option:
PRRIX - PIMCO real return .47

Other bond funds which I am not sure whether I would pay CA or not:

VSGDX - short federal fund admiral .10
PDMIX - PIMCO GNMA .51
DODIX - Dodge & Cox income .42
LHYOX - Lord Abbet high yield .61

There are also a variety of target date funds, balanced funds, stock funds, a REIT…

I noticed that PRRIX and PDMIX are somewhat uncorrelated historically so I don’t hate the idea of holding those as balancing partners.

I’ve been puzzling at this weighing: 50/50 PRRIX/PDMIX VS S&P index fund VS wellington. My quandary is regarding the optimal choice here, given that I do hold bonds in tax deferred accounts (sep and 401k) which I could use to rebalance against. Is the tax benefit of holding govt bonds in the HSA enough to justify the high ER on those active bond funds, and also sufficient to offset the potential additional income I might eventually see in my tax deferred by holding more stocks there?

What else am I not considering?

Thanks for any thoughts/advice. This one has too many moving parts for me to wrap my head all the way around it.
I'd look at rolling your HSA over to Fidelity and just holding total market ETFs. Lower ERs and more favorable tax status.
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Re: HSA with state tax considerations - how to invest?

Post by gas_balloon »

I am in CA state, and I treat HSA similar to other taxable brokerage accounts:
1) Avoid Bonds with taxable dividend yields (Muni funds are ok)
2) Avoid REITs
3) Prefer not to purchase small-cap value
4) Prefer not to purchase Emerging markets
5) Prefer to purchase Total U.S, S&P 500 or Developed international.

I transfer my account from my employer-sponsored HSA to Fidelity at the beginning of each year so I have better investment options. For now all my HSA has is Fidelity Zero Total U.S. Market. In future if necessary, I will buy Developed International Markets as my 2nd choice if my AA needs it.
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Nohbdy
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Re: HSA with state tax considerations - how to invest?

Post by Nohbdy »

Thank you for all of the thoughts and suggestions. I really appreciate the insights.

We do have about 6 months of emergency funds in taxable accounts that we maintain. We also have an out of pocket maximum on our current insurance. So I feel pretty good about being able to cover anything that might come up. I could easily invest some of our current EF more aggressively in taxable to offset holding bonds in the HSA, but it looks like the consensus (or at least a majority opinion) is that the HSA should be in stock index funds. I did a (not robust at all and I probably made mistakes) spreadsheet and It appears to me that stock index in HSA is the more efficient placement given a few assumptions: 1) stocks dividends stay somewhat low, 2) stocks outperform bonds by 4.5%+, 3) my CA tax rate is not much higher when I withdraw, 4) I do not need the money in the next 10 years (thanks artsdoctor).

There are decent low ER stock index funds in my existing plan. After thinking it over I intend to put the invested portion of HSA into VIEIX vanguard extended market ER.05 which seems to be total US minus the S&P. I have a lot of S&P in my 401k already and this MF looks like a good everything else US fund with a low dividend.

I do see that many folks here recommended fidelity. I will definitely take that into account if I need to de-risk this, such as when I hopefully use this account to help bridge to medicare.

Thank you again bogleheads. I was very stuck on this and I can enjoy other things now. :sharebeer
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Re: HSA with state tax considerations - how to invest?

Post by grabiner »

gas_balloon wrote: Fri Jan 14, 2022 5:30 pm I am in CA state, and I treat HSA similar to other taxable brokerage accounts:
1) Avoid Bonds with taxable dividend yields (Muni funds are ok)
2) Avoid REITs
3) Prefer not to purchase small-cap value
4) Prefer not to purchase Emerging markets
5) Prefer to purchase Total U.S, S&P 500 or Developed international.
You don't want to use munis either. While they are exempt from CA tax, you waste the federal exemption; munis in an HSA will yield less after tax than corporate bonds of comparable risk.

Treasuries (including TIPS) are great in a CA HSA if they fit your investment needs. You still get a shelter from the federal tax, and you avoid the CA tax on the dividends. While you will pay tax on the capital gains, these will be relatively small. (In NJ, it is even better; capital gains on "qualified investment funds" which hold Treasuries or TIPS are exempt from state tax.)
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Re: HSA with state tax considerations - how to invest?

Post by nolesrule »

The one thing you do need to keep in the back of your mind if you are in an HSA where you don't get to control the investment lineup is that the fund choices can be changed on you and forced exchanges can be executed.

While living in NJ we took the advice to use a Treasury Fund. Shortly after we moved to another state, the HSA custodian changed the investment lineups (and actually eliminated the Treasury Fund), along with switching some of the other funds as well. The fund changes were generally an improvement, but it's still inconvenient in a state that taxes HSAs.
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Re: HSA with state tax considerations - how to invest?

Post by Artsdoctor »

If your investment horizons are long, as you state, that you can be aggressive in your HSA. The same rules apply as they do to any "taxable" account: find investments that throw off low/efficient dividends, no capital gains distributions, and--as always--low expense ratios.

California does allow you to carryover capital losses so it's possible for you to tax-loss harvest in your HSA. It requires a bit a bookkeeping on your part and your capital gain/loss tally will diverge from your federal tally. If you're up for that, then by all means invest aggressively.

As far as the HSA firm changing investment options, that is easily corrected by simply transferring your assets elsewhere (such as Fidelity). Since you state that you're investing for the long-term, I would very strongly urge you to think about transferring the assets anyway since the longer you invest for, the more important the expenses become.
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Re: HSA with state tax considerations - how to invest?

Post by investmax »

Nohbdy wrote: Thu Jan 13, 2022 6:50 pm
Artsdoctor wrote: Thu Jan 13, 2022 6:11 pm It sounds as if you're already spending 1/2 of the annual contributions to the HSA(s). Can you clarify the reasoning behind that? Is it because you want to or because you have to? If you're spending it and not investing it, would that imply that if you had higher medical expenses this year or next year you'd be compelled to take the funds from the HSA? If so, then is using the HSA as an investment account the best thing to do?

If you think there's a small but real chance that you'll need the funds in the HSA in the near future because unanticipated medical expense, then put the money in treasuries and forget about the tax (you'll owe nothing). Your current investment options are limited but there's nothing that is stopping you from transferring the money to another HSA outside of your work-sanctioned HSA.
Sure, thanks for taking an interest.

We usually spend at or near the out of pocket max for our insurance on HSA eligible expenses, which is $6k. A vast majority of those expenses are single or double digit dollars which we pay out of the HSA directly. If it is hundreds of dollars on a single receipt then we evaluate our funds and most of the time we come out of pocket and save that receipt to reimburse ourselves later. Our organizational skills are ok, but I’m hesitant to add a ton of complexity for the diminishing return per effort involved that collecting dozens of receipts might create. I think we would lose receipts if we tried to do too much.

The small but real chance of needing HSA sooner would involve me losing my job which I have had for over 2 decades. It is not zero, but it is not keeping me up at night.
I have a question regarding saving the HSA receipts. Do we need to physically store them, or just take a picture and store the picture in a 'cloud' folder somewhere. And when we are withdrawing from the HSA do we need to produce the receipts in any chronological order?
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Nohbdy
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Re: HSA with state tax considerations - how to invest?

Post by Nohbdy »

Artsdoctor wrote: Sat Jan 15, 2022 10:44 am If your investment horizons are long, as you state, that you can be aggressive in your HSA. The same rules apply as they do to any "taxable" account: find investments that throw off low/efficient dividends, no capital gains distributions, and--as always--low expense ratios.

California does allow you to carryover capital losses so it's possible for you to tax-loss harvest in your HSA. It requires a bit a bookkeeping on your part and your capital gain/loss tally will diverge from your federal tally. If you're up for that, then by all means invest aggressively.

As far as the HSA firm changing investment options, that is easily corrected by simply transferring your assets elsewhere (such as Fidelity). Since you state that you're investing for the long-term, I would very strongly urge you to think about transferring the assets anyway since the longer you invest for, the more important the expenses become.
We’re on the same page regarding low cost indexing. I would prefer to keep it simple and efficient. As stated above, I think the math is close when comparing: stocks in HSA/bonds in deferred VS bonds in HSA/stocks in deferred. It does seem to boil down to risk tolerance for the HSA and when we might need the money.

It is disconcerting to think about waking up to find my investments shifted around without my input. Actually that feels like it should be a crime (what else can they choose to invest my money in?), although I really have no idea.

It seems like I can choose which complexity I prefer:
1) lesser tax complication, increased broker complication.
2) lesser broker complication, increased tax complication.

It appears unanimous that pushing investments to another broker is the way to go. Folks must get burned or annoyed by these default providers. I guess I am annoyed a bit already with them…

I looked into shifting funds a bit. My employer states that they will only work directly with the provider that they chose (payroll contribution). The current HSA provider will incur a fee to transfer funds to another broker. It is a relatively small fee, but I really do not like fees and this will probably need to be at least an annual transfer. Is there a way to avoid this?

Fidelity seems highly thought of in this regard. I don’t have a relationship with fidelity, but I have several accounts at TD ameritrade already and it seems like TD am offers an HSA brokerage option. The brokerage option may need to be transferred back to the HSA to be spent qualified in the future, which feels kind of high maintenance and potentially fee ridden too.
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Re: HSA with state tax considerations - how to invest?

Post by zincTwo »

My HSA is a small fraction of my total portfolio, that I don't worry about maintaining a bond allocation in there.
I simply use a TSM ETF (ishares ITOT) in my Fidelity HSA. ITOT is reasonably tax efficient. I am planning on leaving CA before the funds will be drawn, so I will experience the tax free growth...so I want to maximize that growth, with minimal maintenance complexity.

Being in CA is a pain for tracking each of the tax lots (in the situation where I may not leave CA). So I let my monthly payroll contributions temporarily stay in the core money-market cash position. Once or twice a year, I do a larger 'buy' into the EFT. That way I only need to track 1 or 2 basis' a year, rather than 24 payroll purchases.
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Re: HSA with state tax considerations - how to invest?

Post by grabiner »

Nohbdy wrote: Sat Jan 15, 2022 4:11 pm Fidelity seems highly thought of in this regard. I don’t have a relationship with fidelity, but I have several accounts at TD ameritrade already and it seems like TD am offers an HSA brokerage option. The brokerage option may need to be transferred back to the HSA to be spent qualified in the future, which feels kind of high maintenance and potentially fee ridden too.
TD Ameritrade doesn't have its own HSA. HSA Bank offers an HSA which allows you to link to a TD Ameritrade account. This is popular with US Government employees, because the most popular US Government HDHP uses HSA Bank, and the fees are waived. If you have your individual HSA with HSA Bank, you will have to keep enough in the bank to waive fees, and can transfer the rest to TD Ameritrade.
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Re: HSA with state tax considerations - how to invest?

Post by Artsdoctor »

Nohby,

It's definitely understandable to be "annoyed." But when you really think about it, it's a very common issue. More widely used than HSAs, a 401k (or 403b, etc) creates unlimited frustration with people who pay attention to these things. Most employees will need to choose from a variety of investment options within the 401k and these can easily change whenever HR decides to revamp their plans. I can go both ways: I've seen poor choices give way to terrific choices; and, inexplicably, I've seen great 401k plans fall off the cliff. If you're currently employed, you don't even have many options here. With your HSA, you can at least transfer the employer-sanctioned to the HSA of your choice.

Generally, the sums in HSAs are relatively small. It's perfect fine to transfer HSA balances from the employer plan to the plan of your choice annually if you'd like to do this.
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