Ideal time/balance to start HSA drawdown?

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MrBeaver
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Ideal time/balance to start HSA drawdown?

Post by MrBeaver » Mon May 21, 2018 7:46 pm

Is there a point under a curve (HSA balance by age) where one should cease to pay out of pocket for medical expenses and save receipts, and instead pay out of their HSA while investing the cash which would have paid for those medical expenses in a taxable account in order to maximize return? Where should this curve be?

Previous discussions have asked about when to stop contributions:
viewtopic.php?t=157115

I'm of the opinion that as long as I have income and am HSA elligible, it makes sense to contribute to get the tax deduction. But when to start drawdown has a sizable impact on the mix of balances in various account types later in life (Roth, tax-deferred, taxable, HSA). The typical 'given' is that drawdown should happen at least by medicare. With a 140k balance and almost 30 years to go before medicare, I'm starting to question whether I should start drawdown prior to that.

My goals:
  • Have enough in HSA to fund medical expenses through retirement on earnings.
  • Retain enough balance in HSA to self-fund a few years of long-term care.
It looks like I'd need to achieve 6.25% return above medical inflation at this point to reach my goals if I were to start drawdown now, so for me it seems too soon as that seems fairly optimistic. However, if I could achieve those returns and waited until medicare to drawdown, then our balance at age 80 would be 2.5M in today's dollars ($1M at medicare age), of which only ~$375k is tax-free from previous expenses.

Upsides to having an HSA balance larger than required to self-fund long-term care:
  • Can use to supplement tax-deferred withdrawals, both to smooth out taxes from RMDs and to keep from withdrawing from tax-deferred prior to RMDs if desired.
  • Self-insurance against running out due to lower returns or higher medical cost inflation.
Downsides to having an HSA balance larger than required to self-fund long-term care:
  • Large balance is taxable to non-spouse beneficiaries in a lump sum, which likely limits this money in estate planning to charitable contributions (which I personally have no problem with).
  • After-tax proceeds from HSA withdrawals might be less than after-tax proceeds from withdrawing earlier tax-free for medical expenses and putting into a taxable account.
I'm most interested in the analysis of and reactions to the final bullet point. My thinking is that if I were to start drawdown while in accumulation phase, I would put the money I otherwise would have used for paying medical costs into taxable investment. I think it's fair to look at this as funding a taxable investment with pre-tax money, while using post-tax money to pay for medical care. As such, it seems that money withdrawn tax-free, growing with a taxable account tax drag and then selling with capital gains tax might net more than leaving it in to compound without a tax drag and then later withdrawal and pay income tax on. I think what I'm seeing is that the value of my 'receipts' by not taking money out tax free until much later is essentially dwindling in real dollars and at some point, that 'loss' in taxes becomes greater than the loss of a taxable vs a tax-deferred account. But there is much here that I'm not fully understanding and I'm pretty sure my cobbled together spreadsheet is not fully sufficient.

I also remember seeing someone suggesting perhaps investing an HSA in a healthcare fund, in order to hedge against high medical inflation. Assume for this thought experiment that there is enough income to max other available tax-advantaged space, so it is a pure question of ideal allocation between HSA and taxable investment vehicles.

sesq
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Re: Ideal time/balance to start HSA drawdown?

Post by sesq » Mon May 21, 2018 10:52 pm

I am not inclined to do the math on your final bullet but I think there would be a lot of variables like whether you planned to retire early and the timetable when you would stop working/stop contributing. With a 30 year time horizon and a the thought that your account may double several times you might be at the point where stopping makes sense, or at least limit the growth in the account to the excess over current year out of pockets. I seem to recall some fidelity (or similar) studies suggesting that retirement medical costs excluding long term care in the ballpark of $250k per person which may mean you are overfunded.

I think the conversion of an HSA from a tax free account to a tax deferred account if inherited by a non-spouse is a bit of an Achilles heel, depending on the beneficiaries tax rate its an immediate 20-40% haircut. I have about 35K in my account and 20K in receipts. We have somewhat high family medical expenses most years. I plan to early retire and I plan to use the HSA with receipts as an early pressure release valve to smooth cashflow while being aware of my tax brackets. This will help me preserve my roth assets or converted roth assets. I may be paranoid about the inheritance risk but I am looking to liquidate the account fully pretty early on.

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willthrill81
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Re: Ideal time/balance to start HSA drawdown?

Post by willthrill81 » Mon May 21, 2018 11:47 pm

MrBeaver wrote:
Mon May 21, 2018 7:46 pm
After-tax proceeds from HSA withdrawals might be less than after-tax proceeds from withdrawing earlier tax-free for medical expenses and putting into a taxable account.
So what you're describing is simply to take advantage of only two of the HSA's tax-advantages: tax-deferred contributions and tax-free withdrawals for medical expenses. You're bypassing the tax-free growth that they experience. It seems that you're logic in doing so would be to have the growth taxed as long-term capital gains in a taxable account rather than as earned income when withdrawn after age 65 from the HSA.

It seems plausible that this strategy could be better than leaving the money in the HSA the entire time, but a lot would depend on other variables. For instance, the marginal rate in retirement might be as low as 0%, even with significant real income, which means that your HSA withdrawals for non-medical expenses might not get taxed at all. It's very plausible that your marginal rate would only be 12%, and the advantage of tax-free growth as compared to the tax-drag of a taxable account could easily offset that, depending on how long the HSA money had to grow.

It seems possible, but you'd have to examine multiple scenarios to see which would work out better in the end.

The way I look at it is this. From a tax perspective, the worst thing about an HSA is that if both I and my wife pass away before it's exhausted, the portion of the HSA balance that our daughter will get to keep may get reduced by about a third. That's a first-world problem if ever there was one. :D
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

Spirit Rider
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Re: Ideal time/balance to start HSA drawdown?

Post by Spirit Rider » Tue May 22, 2018 7:26 am

The main issue is when to take tax-free distributions of the unreimbursed qualified medical expenses. The last thing you want to do is die leaving what could have been tax-free distributions to you, be lump sum taxable income to a non-spouse beneficiary.

The perfect answer is the day before you die. However, that is not generally knowable. This is the dilemma that the OP is try to resolve. Do it too quickly and you are giving up future accumulation that could be tax-free for LTC.

My plan is to start taking "RMDs" in the year I turn 70 1/2. Using the RMD divisor to determine what percentage of the unreimbursed qualified medical expenses to take tax-free distributions of. With the plan to increase the divisor if my projected longevity decreases.

gilgamesh
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Re: Ideal time/balance to start HSA drawdown?

Post by gilgamesh » Tue May 22, 2018 7:41 am

The major benefit of HSA is it’s triple tax free status for eligible expenses. So for things like qualified long term care and Medicare premium I could withdraw tax free. You loose this massive potential with your analogy of investing in taxable with pre-tax funds.

You mentioned tax-free growth advantage of HSA, which needs to be quantified...many variables.

The beauty of HSA is the potential to be triple tax free, and if not needed, the alternative ain’t so bad (just pay taxes upon withdrawal).

I don’t have any inheritance worries, but it’s a good point for those who do. I will keep my HSA for possible LTC...so, probably to the end.
Last edited by gilgamesh on Tue May 22, 2018 8:13 am, edited 1 time in total.

gilgamesh
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Re: Ideal time/balance to start HSA drawdown?

Post by gilgamesh » Tue May 22, 2018 7:55 am

Spirit Rider wrote:
Tue May 22, 2018 7:26 am
The main issue is when to take tax-free distributions of the unreimbursed qualified medical expenses. The last thing you want to do is die leaving what could have been tax-free distributions to you, be lump sum taxable income to a non-spouse beneficiary.

The perfect answer is the day before you die. However, that is not generally knowable. This is the dilemma that the OP is try to resolve. Do it too quickly and you are giving up future accumulation that could be tax-free for LTC.

My plan is to start taking "RMDs" in the year I turn 70 1/2. Using the RMD divisor to determine what percentage of the unreimbursed qualified medical expenses to take tax-free distributions of. With the plan to increase the divisor if my projected longevity decreases.
He is talking about withdrawing money from HSA during the accumulation phase...he is equating that to investing in taxable but with pre-tax dollars.

The question you are raising is very Interesting to me - I would think I’ll take the tax free distribution of un-reimbursed qualified medical expenses when I do Roth conversion and wanted to be in a lower tax bracket...haven’t thought about this completely.

MrBeaver
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Joined: Tue Nov 14, 2017 4:45 pm

Re: Ideal time/balance to start HSA drawdown?

Post by MrBeaver » Tue May 22, 2018 8:24 am

willthrill81 wrote:
Mon May 21, 2018 11:47 pm
MrBeaver wrote:
Mon May 21, 2018 7:46 pm
After-tax proceeds from HSA withdrawals might be less than after-tax proceeds from withdrawing earlier tax-free for medical expenses and putting into a taxable account.
So what you're describing is simply to take advantage of only two of the HSA's tax-advantages: tax-deferred contributions and tax-free withdrawals for medical expenses. You're bypassing the tax-free growth that they experience. It seems that you're logic in doing so would be to have the growth taxed as long-term capital gains in a taxable account rather than as earned income when withdrawn after age 65 from the HSA.
Yes, thank you for summing this up better than I could. I agree that the efficacy of such a plan depends on (1)tax drag in taxable being minimal, and (2)the reduction in tax rate from ordinary income rate to LTCG rate at withdrawal being large enough to make a difference. At this point, it's mostly an academic wondering of how to properly do this analysis going forward – I seriously doubt it makes sense for me yet, but it might at some point.
sesq wrote:
Mon May 21, 2018 10:52 pm
I plan to early retire and I plan to use the HSA with receipts as an early pressure release valve to smooth cashflow while being aware of my tax brackets. This will help me preserve my roth assets or converted roth assets.
gilgamesh wrote:
Tue May 22, 2018 7:55 am
The question you are raising is very Interesting to me - I would think I’ll take the tax free distribution of un-reimbursed qualified medical expenses when I do Roth conversion and wanted to be in a lower tax bracket...haven’t thought about this completely.
These are interesting points I hadn't considered: The possibility of taking qualified withdrawals for previous unreimbursed medical expenses in retirement prior to SS distributions should allow for additional low-tax Roth conversions if desired. Doing so though, requires keeping those receipts and not drawing down the HSA balance early. This is even more complex than I first thought! :shock:

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