A Health Savings Account (HSA) can be one of the most tax-advantaged savings vehicles available for healthcare expenses. An HSA can provide for triple tax benefits to the account holder. Qualified contributions are tax deductible, the funds within the HSA grow tax free, and withdrawals are tax free if used to pay for qualified medical expenses. However, when the account owner dies, special legal and tax rules apply that can significantly impact these results. Proper beneficiary planning is essential to preserve legal and tax benefits and avoid unexpected results. The treatment of an HSA when an account owner passes away depends largely on who is named as the beneficiary.
There are three common scenarios:
- The spouse is the designated beneficiary
- A non-spouse individual is the designated beneficiary
- The estate is the designated beneficiary (or there is no named designated beneficiary, so the account defaults to the estate)
Each has different legal and income tax consequences.
1. Spouse as Beneficiary
If the surviving spouse is the designated beneficiary, the HSA generally becomes the spouse’s own HSA which allows for the following:
- The transfer is generally tax-free
- The spouse assumes legal ownership of the account
- The account continues to retain its HSA status
- The spouse may continue using funds tax-free for qualified medical expenses
- If otherwise eligible, the spouse may continue making contributions
The spouse can continue to use the HSA funds for:
- Medical expenses
- Medicare premiums (in many cases)
- Long-term care expenses subject to IRS rules
2. Non-Spouse Beneficiary
If the designated beneficiary is not the spouse—such as a child, sibling, unmarried partner, friend, or even a trust — The legal ownership of the HSA shifts to the beneficiary outside of probate administration, and the HSA loses its tax-advantaged status immediately upon the owner’s death. The beneficiary generally must include the fair market value of the HSA as ordinary taxable income on the beneficiaries income tax return for the year of death. Further, the beneficiary can no longer continue the account as that HSA. Although the distribution becomes taxable, the additional 20% penalty that normally applies to non-qualified withdrawals does not apply after death.
3. Estate as Beneficiary
If no beneficiary is named, or the estate is designated as beneficiary, the legal ownership of the HSA shifts to the estate so the HSA account will be viewed as a required probated asset. As a result, the HSA funds generally will pass per the account owner’s will or per state intestate rules. This might cause an otherwise non-probated estate to have to file for probate administration and for the HSA funds to pass to unintended individuals. Further, the fair market value of the HSA generally becomes taxable on the deceased owner’s final income tax return. This may create several disadvantages such as accelerated taxable income, potentially higher estate administration complexity, and loss of favorable spousal rollover treatment if the account owner was married. The additional 20% penalty that normally applies to non-qualified withdrawals does not apply after death.
For all three situations above, there are additional income tax planning strategies that may be implemented by the account holder. It should also be noted that HSAs may also be included in the deceased person’s gross estate for federal estate tax purposes so careful estate planning should be considered when dealing with HSA accounts.
HSAs provide valuable tax benefits during life, but beneficiary planning becomes critically important when the account owner passes away. The difference between naming a spouse, a child, friend, trust, or the estate can dramatically affect legal and tax results. Careful beneficiary designations, strong recordkeeping, and coordination with estate and tax planning professionals can help families preserve more value for their loved ones and minimize income and estate tax burdens.
Please contact attorney Jeff Cohen to discuss planning for your Health Savings Accounts so you can make informed decisions.
