Dying with an HSA can leave a tax bomb for heirs
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Building a large balance in a health savings account can be a smart financial move to cover medical expenses in old age.
But according to financial planners, dying with a hefty HSA can create tax problems for heirs, especially non-spousal heirs such as children, grandchildren, friends and others.
That’s the “big unknown” people don’t understand about 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 Snafu.
HSA tax issue
HSAs offer a three-pronged opportunity for tax savings: Contributions and growth are tax-free; Withdrawals are also valid as long as they are used to cover medical expenses such as doctor visits and prescriptions.
Consumers can only contribute to accounts. high deductible health insurance plan.
Financial advisors often recommend users invest their contributions long-term if they can pay for medical care out-of-pocket rather than raiding their HSAs.
Account owners who treat their HSAs this way can build up a sizable balance, as can other investment accounts such as 401(k)s that receive regular contributions and growth. McClanahan, a member of the CNBC Council of Financial Advisers, said one of his clients, for example, had a $600,000 HSA.
Why might large HSAs pose a tax problem after death?
The tax rules are simple when it comes to spouses inheriting an HSA from a deceased account owner: the rules are essentially the same.
The account transfer is not taxable, and the surviving spouse may continue to receive tax-free distributions from the account for qualified medical expenses.
However, this does not apply to non-spousal beneficiaries who inherit HSAs.
According to financial planners, if a non-spouse inherits an HSA, it loses its tax-advantaged HSA status and the assets become taxable income for the beneficiaries in the year of death.
Tax treatment is stricter than the rules governing inherited individual retirement accounts, for example. Non-spousal heirs are generally given a 10-year period to empty the accounts, they said.
This can be a “big problem” for people and “rarely talked about,” said Ryan Greiser, CFP, co-founder of Opulus, a financial advisory firm based in Doylestown, Pennsylvania.
Financial planners have said that inheriting a large HSA as a non-spousal heir could mean they are pushed into the highest marginal tax bracket (currently 37%) in the year they inherit the account.
How to reduce the HSA tax bomb?
There are some potential ways to reduce the tax hit.
“If you know you have an HSA that big, start spending it,” McClanahan said. “There’s no reason to keep a large HSA unless you have a good plan for beneficiaries.”
Account holders can also choose to donate the HSA to charities, which typically don’t owe taxes on the transfer, McClanahan said. He also said that they could distribute the inheritance to multiple people instead of one or two people to ease the tax burden. Account holders should notify heirs in advance to make sure they are well prepared, he said.
Another possible workaround: Non-spousal beneficiaries can offset at least some of their tax liability by using the HSA to cover any of the decedent’s outstanding medical expenses, said Michael Ruger, CFP and chief investment officer at Greenbush Financial Group. wrote in a blog post.
This should happen within 12 months of the owner’s death, experts said.
For example, if the HSA is valued at $50,000 at death and the non-spousal beneficiary uses the proceeds to pay $10,000 of the account holder’s outstanding medical bills, the beneficiary would owe taxes on the remaining $40,000, Ruger wrote.
“This could make a meaningful difference in taxes owed,” he wrote.
