The popularity of Health Savings Accounts (HSAs) continues to grow. The numerous tax benefits (tax deductible contributions, tax-deferred growth, AND tax-free distributions for qualified expenses) are attractive to many families. As health care expenses continue to grow and people look for more ways to keep up with those rising costs, funding an HSA is a choice many people make.
As balances of HSAs continue to grow, it’s important to understand what happens to them if the owner were to pass away. The favorable tax treatment is NOT available to all beneficiaries. Let’s take a closer look at what happens when someone inherits an HSA.
Spouse as HSA Beneficiary
If a surviving spouse inherits an HSA, they become the new HSA owner. The surviving spouse can maintain the HSA and continue to take tax-free distributions for qualified medical expenses. If they have a qualified high deductible health plan and are otherwise eligible, contributions can also be made.
Non-Spouse Beneficiaries Do Not Fare As Well
If you name your children or any other non-spouse beneficiary (other family members, friends, trusts, etc.), the HSA becomes taxable to your beneficiary in the year of your death. Unfortunately, there is no such thing as an “Inherited HSA”. A non-spouse beneficiary is unable to use the funds for their own medical expenses on a tax-free basis and they cannot stretch distributions out over a longer period of time. The entire balance is taxable to the beneficiary in the HSA owner’s year of death.
There is one exception: For up to 12 months after the HSA owner’s death, qualified expenses that were not yet paid at death may be paid with tax-free HSA distributions. In these cases, this income is NOT taxable to the beneficiary.
Distribution Planning with HSAs
Because of the tax benefits and the fact that a wide array of expenses that qualify for tax-free distributions, we typically recommend keeping money in your HSA and paying out of pocket early on to maximize the tax-free growth. As you transition into retirement, you will typically want to start drawing down on your HSA to pay for medical expenses. This strategy most likely results in many years of tax-free growth with sufficient time to spend the accumulated balance on qualified health care expenses.
However, you want to avoid leaving a sizeable HSA to a non-spouse beneficiary, so it’s important to start spending the account down at the appropriate time.
If you’d like to discuss how to most effectively use your HSA, your Shakespeare financial planner would be happy to help!
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