Everything You Need to Know About Inherited HSA

Health savings account or commonly referred to as HSA is a type of savings account. In an HSA, the account holder can contribute money that can later be used for qualified health expenses. HSA is a tax advantaged plan where either the individuals put in money themselves or their employer contribute a fixed amount each year. As per the 2020 limits, people can contribute $3,550 for personal coverage and $7,100 for family coverage. There is also an additional catch up limit of $1,000 for people over the age of 55.

Just like any other savings account, an HSA can also be passed down to a beneficiary in the unfortunate event of the account owner’s demise. However, there are some things that one should keep in mind when dealing with HSAs. Here is everything you need to know about inherited HSA.

There are three scenarios that can play out if the account holder passes away:

1. The spouse is the beneficiaryIf the account holder names their spouse as the beneficiary, the HSA will be passed on to the spouse. There is no change here except that the spouse becomes the account holder upon inheriting it. In such cases, 100% of the funds can be used by the spouse to pay for either their own medical expenses or those of their tax dependents. In addition to this, the spouse can also claim a refund for any medical expenses paid by the account holder from their pocket prior to their demise.
2. The beneficiary is a non-spouseIf the account holder adds a child or any other family member other than their spouse as the beneficiary of their HSA, the account ceases to be a health account. Upon inheritance, the account is treated like any other savings account. The funds in the account are added to the beneficiary’s taxable income of the year in which they inherit it. However, if the recipient uses the funds to pay for qualified medical expenses of the account holder within a year of their demise, this money is deducted from their total taxable income.
3. The beneficiary is the estateIf the beneficiary of an HSA is an individual’s estate, the funds are added to the account holder’s total income at the time of their death and accounted for in their last income tax return.
   

   Things to keep in mind while naming a beneficiary for a health savings account

   Naming a beneficiary for an HSA is not as simple and straightforward as it seems. The inherited account can add on to a beneficiary’s tax liability. In fact, many children prefer not to inherit their parents’ HSAs. The implications of inheriting the account can also differ for married couples, unmarried partners, or same sex couples.

   Here are some things to note before picking out an inheritor:

   1. In the case of married couplesThis may be the most ideal situation as the spouse that inherits the HSA can use it for their own qualified medical expenses. However, they cannot close the account even if they wish to. So, if they need to withdraw funds from the account for any other reason apart from healthcare before the age of 65, they will have to incur a penalty of 20%. This can be unfavourable for some couples who may have financial liabilities other than medical costs.

      Naming a spouse can also have different implications if the account holder’s estate is taxable. In such cases, it is advisable to create a revocable trust as the beneficiary for the HSA. This way, the funds in the account are added to the deceased individual’s taxable income in the year of their demise. However, the individual will gain estate tax exemption that can be used to fund AB trusts. AB trusts are effective estate planning instruments that can be used by the surviving spouse to cover various kinds of expenditure.

   2. In case of an unmarried account holder
      If the account holder is unmarried, they can either name their partner, a child, or a relative as the beneficiary. However, it is vital to consult the beneficiaries before naming them. As stated above, the HSA will be passed on to a non spouse inheritor as a normal savings account. The inheritor will not benefit from any special provisions of the HSA. On the contrary, they are likely to face heavy tax repercussions as the fund value is added to their yearly taxable income. Many people actually choose to not inherit such accounts.
   3. In case of a same sex coupleThere is no difference in the inheritance rules for same sex couples as long as they are married. However, unmarried same sex couples or people in a domestic partnership will be treated as non spousal beneficiaries. In such a case, the death benefit will be added to their yearly income and will be eligible for tax computation.

What is the best way forward?

There is no straight answer to this question. The right inheritor will vary for each individual. However, the most ideal strategy could be to name a spouse as the status of the HSA in such scenarios remains unchanged. The surviving spouse can use the funds to pay for their own qualified medical expenses. They can also pass it down to their heirs when the time comes. Either way, the tax liabilities are at a minimum. One must consult a professional to understand how such inheritances can affect the financial planning of an individual and then make sound and comprehensive decisions.

To sum it up

Health savings accounts are useful tools to create a corpus for healthcare related expenses. They can be instrumental in covering a wide range of costs in some of the most urgent situations. However, it is important to evaluate the pros and cons of naming a beneficiary to avoid any unnecessary hassles later. A person spends their entire life saving money, so letting it all go waste to taxes is not an outcome one should hope for.
If not planned well, a health savings account can impact the tax liability of the inheritor. Therefore, it is crucial to involve an estate planner or Financial Advisor before making these decisions.