Tax-friendly health-savings accounts now allow you to invest in equity mutual funds. But should you?

AS EMPLOYERS LOOK FOR new ways to slash their health-care costs, consumer-directed health plans are getting a sexy new spin.

A consumer-directed plan is one that typically marries a high-deductible insurance policy with a health savings account (HSA). You get a low-cost health care plan that carries an annual deductible of at least $1,000. To cover that hefty deductible, you can set aside dollars in a tax-advantaged account. Any money left in the account at the end of the year can be carried forward to cover future health costs.

Now here's the exciting part: Many Americans will soon be able to invest thier HSA dollars in mutual funds, just like they would with, say, dollars held in an IRA. In fact, large brokerage houses, like Mellon Financial and JPMorgan Chase, have already partnered up with major health insurers like WellChoice and Cigna to begin offering equity-based savings options for these types of accounts.

Because these accounts are funded with pretax money -- and withdrawals are tax free -- HSAs are among the best savings vehicles around. Theoretically, money could grow in stock-based mutual funds over decades, allowing holders to indemnify their health-care expenses as they approach old age. In the meantime, HSAs encourage people to see a doctor only when they think it's absolutely necessary -- lowering costs throughout the health-care system.

HSAs could be coming your way soon. Right now, 8% of large employers offer a high-deductible plan, according to Watson Wyatt Worldwide, a Washington, D.C.-based benefits-consulting firm. Next year this figure is expected to jump to 18%, with some 47% of companies considering these plans. The potential for cost savings makes HSAs especially attractive to large employers. Joe Martingale of Watson Wyatt expects HSAs to catch on quickly.

HSA Basics
A critical component of the consumer-directed plan is the health savings account, which emerged on the scene in January 2004. The HSA allows individuals with qualifying high-deductible health plans to set aside pretax dollars to cover their medical expenses while they spend down their deductibles. Anyone qualifies, regardless of income, with minimum deductibles of $1,000 for single people and $2,000 for families. The maximum HSA contribution for 2005 is the lesser of (1) the amount of your deductible or (2) $2,650 for single coverage or $5,250 for family coverage. If you're lucky, your employer might even contribute to your HSA as an incentive to get you to make the switch.

Unlike the money in flexible spending accounts, HSA balances can be rolled over at end of the year. In fact, it can be rolled over for decades. So if you have a healthy year and don't come close to paying your deductible, you could wind up with a nice chunk of change held in a supremely tax-advantaged account. Because the money is contributed on a pretax basis and is never taxed so long as it's spent on health care, the HSA beats the Roth IRA, the traditional IRA and the 401(k) in terms of tax advantages. Alternatively, you can take HSA withdrawals at age 65 for any reason -- but at that point the withdrawal would be taxed as ordinary income (with no penalty). In that case, the account will have worked much like a 401(k) or traditional IRA.

Up until now, leftover money in these accounts sat in a low-interest bearing checking account. But that's about to change. Now that individuals have had a couple of years to accumulate dollars and meet account minimums, insurers and financial institutions are teaming up to allow them to invest their money in a pool of mutual funds. In other words, your incentive for not seeing the doctor is about to increase significantly. Investing Your Health-Care Dollars
How do these investment accounts work? Let's take a look at the latest offering from Cigna HealthCare. Starting next Jan. 1, holders will have the option to invest in one of six JPMorgan Chase equity funds ranging from an equity index fund to an international growth and income fund. Members must have a minimum balance of $2,000 to participate.

Ideally, individuals should leave a certain amount of money in an interest-bearing checking account to cover expected medical expenses, says Tom Richards, senior vice president at Cigna HealthCare. Anything left over at the end of the year can then be rolled into a mutual fund, provided the balance meets the minimum investment level, which may be as high as $2,000. Should one's health-care expenses exceed what's sitting in the checking account, the member can do one of two things: Pay those bills out-of-pocket with post-tax dollars, or liquidate the mutual funds and transfer the money into the checking account.

Be warned: These accounts are not free. In fact, the fees are quite hefty. Most custodians charge an initial setup fee of $25 to $35. Then, if you choose to invest in mutual funds, the monthly expenses increase to $2 to $4.50 a month. So you could potentially pay $54 a year in monthly fees alone, not including the annual expense ratio and the load fee, if there is one. If you invest $2,000 in a mutual fund yielding 5%, you would find your annual return slashed by more than 50%.

Cigna wouldn't share with us its fee structure, but says it is lower than its competitors.

Spend at Your Own Risk
Just how much can be stashed away in these accounts depends on the individual.

According to the Employee Benefit Research Institute (EBRI), an individual who contributes $1,000 each year could accumulate $23,000 after 10 years, $47,000 after 20 years, $81,000 after 30 years and $127,000 after 40 years, assuming an annual rate of return of 5% and that contribution levels are indexed for inflation.

And if you're lucky enough to be able to set aside the maximum contribution level of $2,600 (for 2004) each year and never touch the account, your savings could increase to $321,000 over 40 years. Of course, you'll also have to pay for any non-reimbursed medical expenses out of pocket, regardless of what ailment may strike you during those long years.

That's why "this model works better as a tax shelter for the upper-middle class than for funding health expenses," says Paul Ginsburg, president of the Center for Studying Health System Change, a Washington, D.C.-based nonpartisan policy research organization funded principally by the Robert Wood Johnson Foundation.

Most Americans, of course, won't be able to exploit HSAs to the fullest. "Once people hit 40 years, they have this problem or that and will use a good chunk of the money they saved," leaving little for retirement health-care spending, says Dean Baker, co-director for the Center for Economic and Policy Research, a Washington, D.C.-based think tank.

Consider an example, courtesy of EBRI. If an individual spends only 10% of his HSA balance each year and rolls over the rest, he is left with just $17,000 after 40 years (using the same investment assumptions as earlier) -- a tiny fraction of the $127,000 that accumulates if the person rolls over every penny each year. And since EBRI estimates that someone who is 55 years old today and lives to age 80 will need a minimum of $137,000 to pay for out-of-pocket medical expenses during retirement, HSAs shouldn't be counted on as a financial savior for all families.

So think hard before you trade in your plush PPO or even that stingy HMO for an HSA. Those plans might not be perfect, but they could be better for you than the HSA alternative.