Dying with an HSA can leave a tax bomb for heirs

Building up a large balance in a health savings account can be a smart financial move to cover medical expenses in old age.

But dying with a hefty HSA can pose tax problems for heirs — specifically, non-spouse heirs like children, grandchildren, friends and others, according to financial planners.

It’s the “big unknown” that people don’t understand about the tax-advantaged accounts, said Carolyn McClanahan, a certified financial planner and founder of Life Planning Partners in Jacksonville, Florida.

The good news is: There are some ways to avoid the snafu.

HSAs offer a three-pronged opportunity for tax savings: Contributions and growth are tax-free; withdrawals are, too, as long as used for qualifying medical expenses like doctor visits and prescriptions.

Consumers can only contribute to the accounts if they have a high-deductible health insurance plan.

Financial advisors often recommend that users invest their contributions for the long term if they can afford to pay for medical care out of pocket rather than raid their HSA.

Account holders who treat their HSA this way can build a sizable balance, as with other investment accounts like 401(k)s that receive regular contributions and growth. McClanahan, a member of CNBC’s Financial Advisor Council, said one of her clients had a $600,000 HSA, for example.

The tax rules are straightforward when it comes to spouses who inherit an HSA from a deceased account holder: the rules are essentially the same.

The account transfer isn’t taxable, and the surviving spouse can continue to take tax-free distributions from the account for qualified medical expenses.

However, that’s not true for non-spouse beneficiaries who inherit HSAs.

If a non-spouse inherits an HSA, it loses its tax-advantaged HSA status and the assets become taxable income for beneficiaries in the year of death, according to financial planners.

The tax treatment is more stringent than rules governing inherited individual retirement accounts, for example, which generally allow a 10-year window for non-spouse heirs to empty the accounts, they said.

It can be “a huge problem” for people and “rarely talked about,” said Ryan Greiser, a CFP and co-founder of Opulus, a financial advisory firm based in Doylestown, Pennsylvania.

Inheriting a large HSA as a non-spouse heir could mean they are pushed into the highest marginal tax bracket, currently 37%, in the year they inherit the account, financial planners said.

There are some potential ways to reduce the tax hit.

“If you know you have that big an HSA, start spending it,” McClanahan said. “There’s no reason for you to keep a huge HSA if you don’t have a good plan for beneficiaries.”

Account holders can also choose to donate the HSA to charity, which generally would not owe tax on the transfer, McClanahan said. They can also spread the inheritance over multiple people instead of just one or two, to dilute the tax hit, she said. Account holders should notify heirs in advance to ensure they are well-prepared, she said.

Another potential workaround: Non-spouse beneficiaries can offset at least some of their tax liability by using the HSA to cover any of the deceased’s unpaid medical expenses, Michael Ruger, a CFP and chief investment officer at Greenbush Financial Group, wrote in a blog post.

This must occur within 12 months of the owner’s death, experts said.

For example, if the HSA has a value of $50,000 upon death and the non-spouse beneficiary uses the proceeds to pay $10,000 of the account holder’s unpaid medical bills, the beneficiary would then owe tax on the remaining $40,000, Ruger wrote.

“This can make a meaningful difference in the taxes owed,” he wrote.