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Q: I have read a few of your articles on inheriting IRAs and I know many of those rules also apply to Roth IRAs but do they apply to HSAs too? Do my beneficiaries get 10 years with those?
— Rick
A.: Rick,
Health Savings Accounts can be fantastic planning tools. They are the only accounts that provide you with a tax deduction for contributions, no taxes on earnings, and tax-free access at any age — if used for qualified medical expenses. However, they are not all that tax friendly when inherited by a nonspouse.
Unlike IRAs, Roth IRAs, and other retirement accounts, Health Savings Accounts (HSA) do not allow for a stretch nor do they give your heirs 10 years to distribute the assets in the account after you die. An HSA has a distinct set of rules applicable when the owner dies. What happens to the funds depends on the designated beneficiary.
If your beneficiary is your spouse, the account becomes their HSA. The transfer of ownership is completed free of probate. For the year in which you die, a contribution can be made based upon your eligibility. Beginning in the year after you die, your surviving spouse’s ability to contribute to the account is determined by their eligibility for that year.
If your beneficiary is a person but not your spouse, the account will be changed to a taxable account in the name of that beneficiary and the full value becomes taxable to your beneficiary in the year of your death. This transfer is completed free of probate. The amount taxable to a nonspouse beneficiary other than the estate is reduced by any qualified medical expenses for the decedent that are paid by the beneficiary within one year after the date of death.
If the beneficiary is your estate or there is no beneficiary designated at the time of your death, the account will be changed to a taxable account in the name of your estate. The full value becomes taxable income on Form 1041, your final tax return. This new account would be included in the probate estate and be paid to whomever that process deems to receive it.
If the beneficiary is a trust, the account will be changed to a taxable account in the name of the trust and the full value becomes taxable income to the trust. This transfer is completed free of probate.
If the beneficiary is a charity, the account will be paid to the charity free of tax. This transfer is completed free of probate.
Due to eligibility limitations and the contribution limitations, most HSAs are not very large so inheriting one as a nonspouse may not push the beneficiary into a high tax bracket. Still, given the potential for taxability of the assets in the HSA upon the owner’s death, some planning is in order.
If you are married, make sure your spouse is named beneficiary. Whether married or not, most people will be better off paying for qualified medical expenses out of the HSA over other types of accounts during their lifetime. Though HSAs are not eligible to make direct donations to charity as can be done from IRAs, HSAs are one of the more attractive types of accounts in one’s estate to leave to charity.
If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line.
Dan Moisand is a financial planner with Moisand Fitzgerald Tamayo. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.
