By Katelyn E. Murray, CFP
Health savings accounts, called HSAs for short, function differently than most other kinds of accounts. I call them financial planning “unicorns” because of how differently they’re handled from a tax and estate planning standpoint. During your lifetime, an HSA can be a very effective savings tool for funding medical expenses. The IRS allows people with a high-deductible, HSA-eligible health insurance plan to contribute money on a pre-tax basis to an HSA ($3,600 per year for individuals and $7,200 per year for those on a family plan as of 2021). You can withdraw that money, both principle and earnings, completely tax-free, provided the funds withdrawn are used to cover qualified medical expenses.
It would seem that funding an HSA is a no-brainer, and I do recommend to many of my clients that they leverage this unique account which can provide triple-tax savings. However, large HSAs can often become liabilities in the context of estate planning when proper forethought and care is not given to understanding how an HSA-inheritance is structured from a tax perspective.
There are three common outcomes for an HSA when the account owner dies:
- If the HSA owner designates his or her spouse as beneficiary on the HSA, the inherited HSA becomes the spouse’s own HSA as of the account owner’s date of death. The money stays invested in the HSA and the surviving spouse’s name is simply added to the account. He or she can then make tax-free distributions from the HSA to pay for their own qualified medical expenses just like the original account owner would have. In this instance, the HSA is not included in the estate, since it becomes the property of the spouse on the account owner’s date of death.
- If the HSA owner designates a non-spouse beneficiary, such as a child, on the HSA, it’s a completely different story.
As of the date of death of the account owner, the HSA is no longer considered an HSA for tax purposes and an immediate, taxable distribution of the entire balance in the HSA is made to the non-spouse beneficiary. He or she must include the HSA balance in his or her taxable income in the year of the account owner’s death.
Since the distribution is due to death, the normal 20% penalty that applies to distributions taken from an HSA that are not used for qualified medical expenses, does not apply and the beneficiary will pay income taxes at their marginal tax rate on the full amount of the HSA balance, but no penalties will apply. Additionally, any portion of an inherited HSA balance used to pay for outstanding medical expenses of the account owner within one year of the account owner’s death will not be taxable to the non-spouse beneficiary.
In this case, the HSA is not included in the estate, since the full HSA balance is taxed as income to the non-spouse beneficiary on his or her own individual tax return.
- If the HSA owner designates his or her estate as the beneficiary on an HSA, the account balance in the HSA is simply included in the deceased owner’s gross income for the year of his or her death. In this case, the HSA is still not included in the gross estate because it is considered income received by the account owner in the year of his or her death and is reportable as income on his or her final tax return.
The key takeaways here are:
- Make sure you have your living spouse listed as beneficiary on your HSA to avoid your death resulting in a taxable distribution of the account.
- If you have no living spouse, consider the tax ramifications of listing a non-spouse beneficiary such as a child, given that 100% of the account balance will be distributed to that child in the year of your death, and it will be taxed at the child’s income tax rate at that time.
- If you are charitably-inclined and plan to leave a portion of your assets to charity, consider listing a charity as beneficiary on your HSA, since they will receive the full amount of the account balance with no taxes or penalties due. You can always leave the rest of your estate—IRAs, Roth IRAs, 401(k)s, brokerage accounts, etc.—to your children, who will benefit from the tax-advantaged status of these accounts and the step-up in cost basis at death.
- Prioritize spending down your HSA (to the extent of your qualified medical expenses, and potentially beyond that extent once you reach age 65 and are no long subject to the 20% penalty for withdrawals not spent on medical expenses) rather than your retirement accounts, because your children and other non-spouse heirs would rather inherit a tax-advantaged retirement account than an HSA.
If you’re interested to learn more about how your HSA will be handled after your death, or if you don’t have an HSA and are interested in learning more about these unique savings vehicles, consider reaching out to a qualified financial professional for help.
About the Author: Katelyn E. Murray, CFP®
Katelyn E. Murray, CFP®, is a fee-only, fiduciary financial planner and behavioral coach with nearly a decade of experience helping clients define their own vision of success and build a reliable path to reach it. Katelyn uses her background in financial psychology and behavioral finance to cultivate an integrated financial planning approach, in which behavioral coaching elements are integrated with traditional planning and wealth management expertise. As a public speaker, she has appeared as a guest on The W Pulse podcast and has been invited to speak at a number of industry conferences nationwide, including Advisor Group’s ConnectED conference and The W Forum.