Health Savings Accounts – What Happens to Your Unused Balance at Death

Health Savings Accounts (HSAs) became law in 2003 (went into effect January 1, 2004) as part of the Medicare Prescription Drug, Improvement, and Modernization Act. The purpose of the HSA was to provide a way for individuals to pay for qualified medical expenses with pre-tax dollars. HSAs were designed to be paired with high-deductible health plans and intended to encourage individuals to take more responsibility for their healthcare expenses and to shop around for the best prices.

HSAs have really increased in popularity because they offer the following tax benefits:

• Contributions are federally tax-deductible (no need to itemize deductions to obtain this benefit).

• Both contributions and earnings grow tax-deferred.

• Distributions for qualified medical expenses are tax-free.

As a result of their incredibly attractive tax features, the number of account holders and the amount of money in HSAs are both on the rise. At the end of 2022, there were over 35 million HSAs, and the total amount of money reached $104 billion. Current projections indicate that the HSA market will approach 43 million accounts by the end of 2025, holding almost $150 billion in assets.

The ideal way to use HSAs is to contribute the annual maximum, invest the money, and pay for current health costs out of pocket via other savings. This allows time for HSA money to grow tax-deferred.

The benefits of HSAs are quite clear. However, one planning area that needs further clarification is: What happens to your unused HSA balance at death? We will explore what options are available to help you avoid making a costly mistake.

HSAs, like most retirement accounts, pass via a beneficiary designation. The account owner has several options to consider when naming a beneficiary. Let’s review the most common options:

• Spouse – If your spouse inherits an HSA, it simply transfers to their name. The spouse assumes ownership of the account and doesn’t pay tax on the balance. The spouse continues to receive tax-free reimbursements from the HSA account for qualified health care costs. For married couples, this is the most logical beneficiary option if you want to continue with the favorable tax benefits.

• Non-spouse – What if you do not have a spouse? Upon the account owner’s death, the non-spouse beneficiary will have to pay taxes on the account balance in the same year. The tax benefits cease to exist upon the death of the original owner.

• Estate (or no beneficiary listed) – The fair market value of the account will be included as income on the owner’s final income tax return and the HSA will be distributed to the estate.  If you don’t have a will, then your estate would be subject to state intestate laws. It is better to name a beneficiary than have no control over the assets and let the state decide who receives the assets.

• Trust – When a trust (revocable or irrevocable) is named, the fair market value of the account will be included on the owner’s final tax return. This may be a good option if your beneficiary is a minor.

• Charity – If you do not have any heirs, you can always leave your HSA to a charity. The charity does not pay the taxes on the inherited amount.

One unique aspect of HSAs is the ability to get reimbursed for any qualified medical expenses that were incurred after the HSA was opened but paid out-of-pocket from funds outside the HSA. There is no reimbursement time limit as to how far back you can go. You can go back years and even decades. Therefore, the onus is on the account owner to keep detailed medical receipts.

The owner of the inherited HSA may need to take certain action if there are unreimbursed expenses from the original owner. If you are naming a non-spouse beneficiary on your HSA, it’s important for the owner to communicate their wishes. Let’s say the owner kept old healthcare receipts that were paid from non-HSA funds. The non-spouse beneficiary has up to one year from the owner’s date of death to use HSA funds to pay for any qualified medical expenses. The inheriting non-spouse beneficiary can reduce their HSA taxable distribution by the amount of medical expenses incurred by the original owner prior to death and paid by the inheriting beneficiary in the year after the death.

Example: John has an HSA balance of $50,000. His wife is deceased and therefore names his daughter Katie as the beneficiary. Three months after John’s death, Katie pays $10,000 of John’s bills for previous unreimbursed medical expenses. Katie would have $40,000 of ordinary income in the year of John’s death from receiving his HSA: $50,000 balance less $10,000 medical expense reimbursement.

HSAs have now been in existence for 20 years. Owners who have been contributing for decades can easily have balances in the six figures. The favorable tax treatment has led many people to consider their HSA as another type of retirement account by letting the account grow for future healthcare costs.

If there is a high probability that you will have a large HSA balance at death, it is ok to start spending down your HSA. Once you are past age 65, distributions that aren’t used for qualified medical expenses are taxed as ordinary income. Distributions for non-medical reasons made before age 65 are also subject to a 20% penalty. This can still be an attractive strategy if you are in a low tax bracket. It can also be used as a deathbed strategy if the owner is in a lower tax bracket than the non-spouse beneficiary.

Final Thoughts – HSAs are arguably the most tax favored accounts to own during one’s lifetime. The favorable tax treatment remains in place when passing an HSA to a spouse. However, the tax advantage of an HSA can turn into a big tax liability if left to a non-spouse.

Planning to avoid the hidden HSA death tax includes taking reimbursements from the HSA later in life and/or naming a charity as the primary beneficiary on an HSA if the owner is not married.

Please feel free to share this article with your HSA beneficiaries or anyone who may find it useful. I also encourage you to contact your JMG advisor to discuss the benefits of HSAs and an appropriate strategy if you do have an HSA with a large balance.

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