Dying with an HSA can leave a tax bomb for heirs

Building a large balance in a health savings account can be a smart financial move to cover medical expenses in old age.

But dying with an HSA burdened can create tax problems for heirs — especially, non-spouse heirs such as children, grandchildren, friends and others, according to financial planners.

“It’s the biggest unknown” people don’t understand about tax-advantaged accounts, says 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 a snafu.

HSAs offer a three-pronged tax-saving opportunity: Contributions and growth are tax-free; waivers, too, as long as they are used for eligible medical expenses like doctor visits and prescriptions.

Consumers can only contribute to accounts if they have a high-deductible health insurance plan.

Financial advisors often recommend that consumers invest their money long-term if they can afford out-of-pocket medical care rather than raiding their HSA.

Account holders who manage their HSA this way can build a large balance, as can other investment accounts such as 401(k)s that receive regular contributions and growth. McClanahan, a member of CNBC’s Financial Council, said one of his clients has a $600,000 HSA, for example.

The tax rules are straightforward when it comes to spouses who receive an HSA from a deceased account holder: the rules are the same.

Transfers from the account are tax-free, and the surviving spouse can continue to take tax-free distributions from the account for qualified medical expenses.

However, that is not true for non-spousal beneficiaries who inherit HSAs.

If a non-spouse inherits an HSA, it loses its tax-advantaged HSA status and the assets become the beneficiary’s taxable income in the year of death, according to financial planners.

The tax treatment is stricter than the rules governing inherited retirement accounts, for example, which typically allow a 10-year window for non-spouse heirs to empty the accounts, they said.

It can be a “huge problem” for people and “not often talked about,” said Ryan Greiser, CFP and founder of Opulus, a financial advisory firm based in Doylestown, Pennsylvania.

Earning a large HSA as a non-spouse heir can mean they’re thrown into a much higher tax bracket, currently 37%, in the year they get the account, financial planners say.

There are some possible ways to reduce the tax impact.

“If you know you have that big of an HSA, start using it,” McClanahan says. “There’s no reason to keep a large HSA if you don’t have a good plan for beneficiaries.”

Account holders can also choose to donate the HSA to a charity, which typically would not owe tax on the transfer, McClanahan said. They can also spread the inheritance over many people instead of just one or two, to reduce taxes, he said. Account holders should notify heirs in advance to ensure they are properly prepared, he said.

Another potential benefit: Non-spouse beneficiaries can offset at least some of their tax liability by using an HSA to cover any unpaid medical expenses of the deceased, Michael Ruger, CFP and chief investment officer at Greenbush Financial Group, wrote in a blog post.

This must happen within 12 months of the owner’s death, say experts.

For example, if an HSA is worth $50,000 when the person dies and the non-spouse beneficiary uses the proceeds to pay off $10,000 of the account owner’s unpaid medical bills, the beneficiary then owes taxes on the remaining $40,000, Ruger writes.

“This can make a big difference in the taxes owed,” he wrote.