Fluent in Practice Management

Health Savings Accounts can offer great tax advantages during life. But when the account owner dies, the rules change and the tax result depends heavily on who inherits the account. An issue that is commonly seen is that families assume an HSA works like a retirement account. In most cases it does not. A surviving spouse is treated very differently from an adult child, and naming an estate as beneficiary instead of an individual can also change the outcome.

Here is a practical overview of the federal tax rules around inherited HSAs and a few planning steps that can help avoid surprises.

When an HSA owner dies, the account passes according to the designated beneficiary on file, not necessarily according to the will or trust. This is why beneficiary forms are important.  From a federal income tax standpoint, there are three main possibilities for designating the beneficiary:

1. The surviving spouse is the designated beneficiary
2. A non-spouse beneficiary is the designated beneficiary
3. The estate receives the account, either because the estate was named or because there is no valid stated beneficiary

If the surviving spouse is the beneficiary

This is generally the simplest and most tax beneficial outcome.

When the deceased owner’s surviving spouse is the designated beneficiary, the HSA is treated as if it were the spouse’s own HSA. So, the account continues as an HSA rather than ending at death.  This means that:

1. There is no immediate taxable income at the time of inheritance
2. The spouse can continue to use the HSA for qualified medical expenses
3. Future distributions are taxed under the normal HSA rules
4. If the spouse is otherwise eligible, the spouse can continue making HSA contributions going forward

If a non-spouse individual is the beneficiary

This is where many people are caught off guard.

If the beneficiary is anyone other than the surviving spouse, such as an adult child, sibling, or other individual, the account stops being an HSA as of the date of death. That means the beneficiary does not continue the account as an inherited HSA in the way a spouse can.  This means that:

1. A liquidating distribution is completed to the beneficiary.
2. The non-spouse beneficiary must include in their income the fair market value of the HSA on the date of death In the instance of a death, no additional 20% tax is applied
3. This income is reported on the beneficiary’s return for the tax year that includes the date of death

However, there is one important tax break to know about.

A non-spouse beneficiary can reduce the taxable income otherwise recognized from the inherited HSA by paying the deceased person’s qualified medical expenses if:

1. the expenses were incurred before death
2. the beneficiary pays them within one year after the date of death

This requires good recordkeeping and the beneficiary will need to document:

1. The qualified expenses
2. The date that the expenses were incurred
3. The date of payment

If the Estate Is the Beneficiary

 If the HSA goes to the estate, the account is no longer considered to be an HSA. But instead of the income being reported by a non-spouse beneficiary, the fair market value of the account is included on the decedent’s final income tax return.  This amount is also included in the deceased owner’s total estate and subject to the estate tax exemption amount.  If an estate tax is actually paid on the inherited HSA’s value, there may be a deduction available to mitigate double taxation.

Key points to take away

1. a spouse beneficiary usually gets the most favorable treatment
2. a non-spouse beneficiary generally inherits an immediate tax liability with the account balance
3. the estate as beneficiary shifts the income to the decedent’s final tax return, but the income is includable in the gross estate

Below is a side by side comparison.