This weekend I stumbled across with Wealthfront piece titled “Think Carefully Before Signing Up For A High Deductible Health Plan (HDHP).” For the uninitiated, a HDHP is a plan with a large enough deductible to qualify for the use of a Health Savings Account (HSA). An HSA allows the user to contribute up to $6,550 per year pre-tax (assuming family coverage) and use the funds tax-free for medical expenses. I won’t bother going into a big analysis of a HDHP vs. a regular PPO plan, because my friend Jonathan at Wealth Engineers has already done that. The short answer: if you have the cash flow to afford the possibly larger deductibe, a HDHP very often makes sense (doubly so if you are reasonably healthy or paying your own insurance premiums).
But Wealthfront doesn’t want you to choose the HSA, and they use some pretty questionable math to try to convince readers they are better off NOT taking the tax deduction and instead (wait for it…) investing with Wealthfront! So here’s how the math really works. Everything below is from my own family’s health insurance policy and HSA.
We are on a “Bronze” level family plan from the Colorado exchange. Premiums for the non-HSA PPO and the HDHP HSA eligble plan are comparable and it still makes sense to use the HDHP plan due to similar out-of-pocket maximums and the tax benefits of an HSA.
We’ll assume that we contribute $5,000 to the HSA this year and that we’re at a 33% combined State and Federal income tax marginal rate. Remember the HSA is an above-the-line (not itemized) deduction without an income limitation. (Clearly, the higher your taxable income, the more valuable an HSA contribution can be.) Thanks to the tax benefit of the HSA, the comparable amount you would be able to invest in an after-tax account is $3,333.33. This is the huge piece missing from Wealthfront’s analysis – they completely ignore the value of the up-front income tax deduction (which makes the after-tax investment look much better).
Our HSA is at HSA Bank. We have no monthly/annual fee after meeting the balance waiver amount of $5,000 for 2015. Also, there is no monthly fee for investment access (via TD Ameritrade) if you maintain the minimum cash balance of $5,000. We will do this, as it is prudent to keep uninvested cash available if you plan to use the HSA for possible medical expenses. (In practice, this means we’ll start investing in year 2, but we’ll ignore that for the purposes of this illustration).
At TD Ameritrade we can buy any fund or ETF for a nominal fee. ETF trades are usually the cheapest, so let’s assume we buy the Vanguard All-World Stock ETF (VT) for our $5,000. TD Ameritrade will charge $9.99 to place the trade and there are no ongoing costs other than fund expenses. Our net investment is $4,990.01.
The HSA account will grow tax-deferred (and in fact tax-free if the money is used for medical expenses) and the after-tax account will be subject to income tax. To give Wealthfront the benefit of the doubt, we’ll assume the after-tax account never realizes a capital gain and only pays taxes on dividends. With an assumed 20% combined State and Federal tax rate on dividends and a 2% dividend yield on the portfolio, this will cause a drag of 0.40% on returns. Note this is different than the absurdly low 0.04% tax rate Wealthfront tells you is possible. Heads up: you can’t escape taxes on dividend income.
So how can things really look after 20 years? If we assume an 8% gross return, 0.15% expenses on investments, 0.25% Wealthfront charges and 0.40% taxes on the Wealthfront portfolio:
The low-cost HSA ends with $20,974 and the Wealthfront account ends at $12,489. Now, Wealthfront wants to compare the after-tax value of this money, which may or may not be appropriate. If you are using the HSA for medical expenses, you get to spend the pre-tax money. So that is a home run. But let’s assume that you need to spend the money for non-medical reasons, such as if you’ve deferred the HSA into retirement.
The HSA money is fully taxable as ordinary income, and we’ll use the same 33% marginal rate we did on the way in. The $20,974 reduced by income taxes is $13,982.
Since we never paid a capital gain on the Wealthfront money, it’s time to pay the piper. 6% of our 8% return came from capital gains, so after accounting for dividend reinvestment and our initial cost basis, we pay around $860 in capital gains taxes (at 20%), leaving us with $11,629. The HSA still comes out ahead even after a big ordinary income tax hit.
Of course, the way that Wealthfront arrives at their calculations is to make onerous assumptions about how your HSA will perform and spectacular assumptions about how efficient their own portfolios are. It’s not difficult to mislead people with numbers. I’ve reviewed many HSA offerings from clients and can’t say that I have ever seen anything so bad that would result in 3%+ annual underperformance due to fees. Wealthfront calls the HSA a “lousy investment vehicle” which is like saying an IRA is a “lousy investment vehicle” because some IRAs are offered by insurance companies and come with terribly expensive products. Wealthfront also states “the attractive tax treatment applied to an HSA should in no way influence your decision,” which makes absolutely no sense to people in the real world. Why anyone would ignore an opportunity for an above-the-line tax deduction in their analysis is a mystery to me.
I don’t find this too different than Betterment telling people to invest their emergency fund. The incentive of any AUM-based advisor (real or “robo”) is to gather investable assets. They aren’t necessarily truly independent of their own conflicts. So be careful taking financial planning advice from anyone whose sole purpose is to invest your money.