In taxable accounts, we understand that there is tax drag associated with paying long term capital gains (LTCG) rates on qualified dividends. But what often seems ignored is that the deflationary effect of inflation on previous year's qualified medical expenses which authorize future qualified withdrawals from an HSA also represents a tax drag. Essentially, inflation of x% deflates the value of a receipt by (1/(1-x))-1 which then causes an effective tax drag in the HSA of ((1/(1-x))-1) * (income tax rate)% at the time of withdrawal. Income tax rates have been higher than LTCG rates for some time, and historically (since 1974, at least), inflation has been higher than dividend yields. Thus, the tax drag per year of qualified dividends in a taxable account is less than the effective tax drag per year of deflated prior qualified medical expenses in an HSA because both coefficients which determine effective HSA tax drag (inflation and income tax rate) are higher than the coefficients which determine taxable account tax drag (dividend yield and LTCG rate). Historical yield vs inflation (data from http://www.multpl.com/s-p-500-dividend-yield/):Paying current expenses out of pocket
If you are maxing out your retirement accounts, you should treat the HSA as an opportunity for further savings, like an IRA, and not withdraw from it until you retire. If you have $1,000 in medical bills, paying them from your taxable account leaves the $1,000 in the HSA to grow tax-free (and keeps the right to withdraw $1,000 tax-free in a future year), while paying them from the HSA leaves $1,000 in your taxable account, which will grow subject to taxes since you do not have any room for tax-sheltered contributions.
Once you are retired, you can withdraw from the HSA an amount equal to your past medical expenses plus any current expenses tax-free, and withdraw from your other accounts for non-medical expenses. HSAs can be used to pay medicare premiums and other medical expenses in retirement.
To be fair, this deflationary tax drag does not compound like a taxable account tax drag because the money is tax-deferred (the value keeps earning returns until the withdrawal is taken). This means that the longer the money stays in the account, the more likely keeping it in the HSA will yield more after-tax dollars after paying income tax on the deflated portion of the previous medical expense which is now not a qualified expense due to the deflation of the receipt value. Assuming at least as much value from the HSA will be taxed as we have lost from deflation of prior year's medical expense receipts, the after-tax dollars we have to spend from HSA investments starts off with an advantage toward withdrawing the money from the HSA and investing in a taxable account. As time continues, the advantage shifts toward keeping it in the HSA and paying income tax on it, but that cutoff line appears fairly late. With a 7% higher income tax rate than LTCG tax rate in retirement (22% income, 15% LTCG) and inflation 0.5% higher than dividend yield, I compute that it takes roughly 25-30 years for leaving the money in the HSA due to compounding to exceed the after-tax money we would have if we withdrew it earlier (tax-free) and invested in a taxable account at LTCG rates. This time lengthens dramatically as the delta between income tax rates and LTCG rates increases. For example, at a delta of 13% (28% income tax, 15% LTCG) it takes 45 years. 7% is the current minimum delta between LTCG rates and federal income tax rates, with the exception of an individual whose income is below the standard deduction (0% income tax rate). The time to break even on HSA invested funds vs taxable also increases as inflation grows relative to dividend yield, and shrinks slightly as real investment returns increase (due to additional compounding power).
Am I missing something here?
If this analysis is accurate, then it seems a prudent HSA balance to 'stop' HSA growth at by taking distributions for medical expenses and investing that money in a taxable account would be a balance which provides a SWR for total maximum out of pocket medical expenses, along with enough growth to ensure that SWR will increase slightly at retirement to cover Medicare premiums also. It is likely the principal which provides a SWR of medicare premiums + expenses would also provide a decent cushion for long-term care if needed.
The risks with this strategy are:
- LTCG rates cease to be lower than income tax rates
- Long-term dividend yields rise above inflation in the future like they were prior to 1974
- Medical expenses rise faster than expected (expected medical inflation would be used to compute SWR)
What are your thoughts?