Dying with an HSA can leave your heirs with a tax bomb

Building up a large balance in a health savings account can be a smart financial move to cover your medical expenses in retirement.

But financial planners say dying with a large HSA can create tax problems for your heirs, specifically non-spouse heirs such as children, grandchildren and friends.

Carolyn McClanahan, a certified financial planner and founder of Life Planning Partners in Jacksonville, Fla., said tax-advantaged accounts are a “big unknown” that people don’t understand.

The good news is that there are ways to avoid dangerous situations.

HSAs offer tax savings opportunities on three fronts. Contributions and growth are tax-free. Withdrawals are also available as long as they are used for eligible medical expenses, such as doctor visits and prescriptions.

Consumers can only contribute to this account if they are enrolled in a high-deductible health insurance plan.

Financial advisors often recommend investing contributions long-term rather than raiding an HSA if you can afford to pay your medical expenses out-of-pocket.

Account holders who treat their HSAs this way can build sizable balances, similar to other investment accounts such as 401(k)s that receive regular contributions and growth. McClanahan, a member of CNBC’s Financial Advisory Council, said one of her clients, for example, had a $600,000 HSA.

The tax rules for a spouse inheriting an HSA from a deceased account holder are simple. The rules are essentially the same.

Direct deposits are not taxed, and the surviving spouse can continue to take tax-free distributions from the account for qualified medical expenses.

However, this does not apply to non-spouse beneficiaries who inherit an HSA.

According to financial planners, when a non-spouse inherits an HSA, the HSA loses its favorable tax status and the assets become taxable income to the beneficiary in the year of death.

They said this tax treatment is stricter than, for example, the rules governing inherited individual retirement accounts, which typically allow non-spouse heirs a 10-year grace period to empty the account.

Ryan Glaser, a CFP and co-founder of Doylestown, Pennsylvania-based financial advisory firm Opulus, said this can be a “big issue” for people, but “rarely is it talked about.”

Financial planners say that inheriting a large HSA as a non-spouse can put you in the highest marginal tax bracket, currently 37%, in the year you inherit the account.

There are several ways that you may reduce your tax burden.

“If you know you have an HSA that big, start using it,” McClanahan says. “There’s no reason to maintain a large HSA without proper planning for the beneficiaries.”

Account holders can also choose to donate their HSAs to charity, and charities typically don’t have to pay taxes on the transfer, McClanahan said. In addition, inherited assets can be distributed among multiple people rather than just one or two people to reduce the tax burden. Account holders should notify their heirs in advance to ensure they are adequately prepared, he said.

Another possible workaround: Non-spouse beneficiaries can offset at least a portion of their tax liability by using the HSA to cover the deceased’s unreimbursed medical expenses, Michael Luger, CFP and chief investment officer at Greenbush Financial Group, wrote in a blog post.

Experts say this must be done within 12 months of the owner’s death.

For example, if an HSA is worth $50,000 at the time of death and a non-spouse beneficiary uses the proceeds to pay $10,000 of the account holder’s unreimbursed medical expenses, the beneficiary would owe taxes on the remaining $40,000, Ruger wrote.

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