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The Legacy Benefits of Health Savings Accounts

Published on: Aug 31 2021

The main benefits of health savings accounts (HSAs) are delivered during your lifetime, as I discussed in last month’s issue.

Another benefit is that an HSA also can build a legacy, so it should be carefully considered as part of your estate plan. An HSA is not a use-it-or-lose-it account. You can name a beneficiary to inherit the account. When you don’t name a beneficiary or name your estate, the HSA will be distributed to your estate.

In that case, the account will stop being an HSA and the entire account balance will be included in gross income on your tax return for the year of your death. There’s better treatment when your spouse is the beneficiary. The account will remain an HSA, and your spouse will be its new owner.

Distributions to pay or reimburse qualified medical expenses for your spouse and his or her dependents will continue to be tax free. The surviving spouse also can take tax-free distributions to the extent you or the surviving spouse paid or incurred unreimbursed medical expenses in the past. Distributions to pay for expenses other than qualified medical expenses will be taxed to the surviving spouse the same as distributions from a traditional IRA.

When the beneficiary is an individual other than your spouse, the ac- count stops being an HSA on the date of your death. The account balance is distributed to the beneficiary or converted to a taxable account for the beneficiary. In either case, the account balance on the date of your death is included in the beneficiary’s gross income, as are any income or gains earned after your passing.

But any unreimbursed qualified medical expenses you incurred and that the beneficiary pays within one year of your death reduce the taxable amount. That creates an opportunity for taxes on the inherited HSA to be substantially reduced and perhaps eliminated.

Last month, I advised that you should maximize the HSA’s value leading up to retirement. Then, use distributions from the HSA strategically during retirement to minimize your tax bill.

The HSA can be used to take tax-free distributions to reimburse you for qualified medical expenses you incurred in previous years that hadn’t been reimbursed. The same strategy apparently can reduce the taxes your beneficiary has to pay on the HSA.

Of course, the beneficiary can reimburse the estate for any reimbursed medical expenses incurred just before you passed.

But the IRS rules don’t say the reimbursable expenses are limited to those incurred just before your death. The tax rules say the amount of the HSA that is taxable to a non-spouse beneficiary are reduced by any qualified medical expenses of the decedent that are paid by the beneficiary within one year of the owner’s death.

It looks like the beneficiary can pay your estate for reimbursed expenses incurred by you and use that amount to reduce the taxable amount of the HSA. The beneficiary or other heirs then would inherit the payments tax free through the estate, according to the terms of your will. Keep a good record of the qualified medical expenses you paid and that haven’t been reimbursed.

Be sure your executor knows where to find those records. Then, the executor can give the records to the HSA beneficiary. IRS rules aren’t clear if the reimbursements must be for only medical bills that were outstanding at the time of your death or can be for medical expenses you paid previously that weren’t reimbursed. Because the IRS guidance isn’t explicit, this should be considered an aggressive tax strategy.

An alternative way to spare your heirs taxes on the inherited HSA would be to name either your revocable living trust or estate as the beneficiary.

I don’t recommend this strategy with IRAs, but it can be a good strategy for HSAs. The income taxes would be paid by your estate or the trust instead of by the beneficiary. Another option is to name a charity as the HSA beneficiary. Let your family members inherit other assets that aren’t taxable and make your charitable be- quests using an HSA.

The charity won’t be taxed on the HSA balance, but an individual would. Another way to build a legacy with HSAs is to ask your children about their use of HSAs. Suppose an adult child qualifies for an HSA because he or she is covered by a high-deductible medical insurance policy, but the child’s employer doesn’t contribute the maximum amount to the HSA. The child doesn’t have the cash flow to fully fund the account. You can make contributions to the HSA for the child as part of your estate planning gifts.

Total contributions to the HSA for the year from all sources can’t exceed the annual limit. The contribution counts toward your annual gift tax exclusion amount of $15,000. You won’t be able to deduct the contribution because the HSA isn’t covering you or a dependent. Or you can give the cash to the child, who can contribute it to the HSA and deduct the contribution. You’ve helped create a tax-free balance for your child. The child can invest the account and let the balance com- pound over the years.

Or the balance can be used to pay family medical expenses the child can’t pay from current income. Funding a child’s HSA is a good way for you to make tax-wise gifts.

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