HSA Tax and Inheritance Rules for Nonspouse Heirs

A health savings account (HSA) is the only investment vehicle that's triple tax advantaged: Contributions are pretax (via payroll deductions) or tax-deductible (outside of payroll); potential growth of invested assets is generally tax-free at the federal level; and distributions are tax-free when used for qualified medical expenses. (California and New Jersey do not allow the deduction of HSA contributions for state tax purposes, and both consider capital gains and interest from HSAs as income.) Better still, these benefits extend to surviving spouses.

But for nonspouse beneficiaries of an HSA, the tax advantages can vanish. "Nonspousal heirs are forced to realize the entire account balance as income in the year of the owner's death, potentially triggering a substantial and unexpected tax liability," says Austin Jarvis, director of estate, trust, and high-net-worth tax planning research at the Schwab Center for Financial Research.

If you find yourself with an HSA balance that far exceeds your and your spouse's anticipated medical needs, it could be time to pivot. Consider:

• Maximizing qualified expenses: Qualified expenses are broader than you may realize, encompassing dental and vision services, medical equipment like motorized wheelchairs, Medicare premiums, premiums on long-term care insurance policies, and even certain home modifications like grab bars for bathrooms and showers.
• Paying yourself back: HSAs allow for retroactive reimbursement of qualified expenses, provided they were incurred after the account was established and you've kept receipts and other necessary records. This benefit even applies to your estate. "If you have a backlog of unreimbursed or unpaid medical bills, your executor has one year from your date of death to use the HSA funds to reimburse the estate or your medical providers," Austin adds.
• Using the funds for income: After you reach age 65, you can make penalty-free withdrawals from your HSA for any purpose, although you'll owe income tax on the distributions—similar to withdrawals from a traditional 401(k) or IRA. "Using HSA funds as income can potentially help preserve other, more tax-efficient assets for heirs," Austin says.
• Donating the balance to charity: If philanthropy is part of your estate plan, you could name a charity, rather than an heir, as the beneficiary of your HSA. "In doing so, your estate receives a charitable deduction for the full pretax value of the account," Austin says.

"The bottom line is you should make every effort to fully capture the tax advantages of these accounts during your or your spouse's lifetime," Austin says. "Otherwise, taxes could significantly reduce what's left to your heirs."