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Personal Finance

Handling HSAs After Death or Divorce

Many health savings accounts have grown quite large and merit careful consideration in divorce or inheritance planning.

A verion of this article originally published in October 2016.

Remember when IRAs were a new idea? Then they became mainstream, and then we began to commonly see them as assets to be dealt with in death and divorce. And so it is with health savings accounts (HSAs). They may still seem like a new idea, but HSAs have now been with us for 13 years, and some of the balances have become quite large.

Health Savings Account Basics
HSAs are tax-exempt custodial accounts. Tax-deductible contributions can be made up to specified annual amounts, there are no income restrictions for contributing, and they must be used in conjunction with a qualified high-deductible health insurance plan. You can continue to withdraw from the HSA plan to cover qualified medical expenses even after you are no longer eligible to contribute, usually due to a change in health insurance plan or hitting age 65. Medicare recipients can no longer contribute because they are covered by Medicare Part A and cannot qualify for a high-deductible plan. HSA dollars can be used to pay for Part B premiums but not Medicare supplement policies.

Funds that are withdrawn and not used for qualified medical expenses are considered to be taxable distributions and are subject to a 20% penalty unless the taxpayer is 65 or older.

The current HSA maximum contribution for a family is $6,750, and $3,400 for a single person ($4,400 if over age 55). Contribution limits are indexed for inflation, and the accounts can be invested as aggressively or conservatively as desired. Many HSA contributors prefer to allow the accounts to grow for future use rather than using them for medical expenses, so it's not hard to believe that a considerable number of accounts are now worth over $100,000.

HSAs and Divorce
At first it was hard to believe: A client in the process of divorce came in with a list of family assets, and one of them was a health savings account in the amount of $85,000. Neither the advisor nor the attorney had ever encountered an HSA as part of property division, and both were quite surprised at the amount. The next question was, "How should it be divided?"

HSAs are actually handled like IRAs in a divorce. Interest in an HSA can be transferred between spouses as part of a divorce or separation agreement. It is not considered a taxable transfer, and the interest that is transferred keeps its identity as an HSA for the receiving spouse. The transferred HSA can be moved to a new trustee or administrator if desired and invested as the recipient sees fit. Expenses incurred before the new HSA is established are not qualified for reimbursement. In order to avoid this gap, trustee to trustee transfer is recommended, rather than a direct rollover. 

IRS guidelines allow for either parent to use HSA funds for children's eligible expenses, no matter which parent is taking the children as dependents for tax purposes and regardless of which parent has physical custody of the children.  

Quite often, ex-spouses will be required to keep their former spouses on their medical plan for a period after divorce. However, they may not use their own HSA to cover the former spouse's eligible medical expenses. Funds withdrawn for such a purpose are taxed as ordinary income and are subject to the 20% penalty unless the taxpayer is 65 or older.

It is legal for one ex-spouse to make an HSA contribution to the account of an eligible former spouse. However, the individual who owns the HSA gets the deduction.

HSA beneficiaries should be updated after divorce to prevent an unintended distribution at death.

Inherited Health Savings Accounts
An HSA inherited from a spouse is a straightforward situation. The account becomes the account of the surviving spouse, and he or she has all the same rights as the original owner. There is no tax impact if the funds are used to pay for eligible medical expenses.

HSAs inherited by non-spouses stop being HSAs. The fair market value as of the date of death becomes taxable to the beneficiary as ordinary income. If the estate is the beneficiary, the value of the HSA is included in the final tax return. The taxable amount may be reduced by any qualified medical expenses incurred by the decedent that are paid by the beneficiary within a year after the date of death. Funeral expenses are not qualified for HSA reimbursement.

There is a good case for allowing the HSA balances to grow as a cushion for high medical expenses later in life, but consideration should also be given to the inheritance tax disadvantage. Eventually using up the tax-free dollars for medical expenses or naming a charity as beneficiary can mitigate or eliminate the tax consequences.

Tax Forms
IRS Form 8889 is required to be filed whenever there is activity in an HSA, even if contributions are the only activity and even if someone else or an employer made the contribution on your behalf, such as the divorce situation mentioned above. If HSA distributions are received, the form must be filed with the 1040 even if there is no taxable income or other reasons for filing. A surviving spouse who inherits an HSA files the Form 8889 as if the HSA were their own. 

If the beneficiary is a non-spouse or the estate is the beneficiary, the form must still be filed. Form 8889 instructions contain the specific wording that must accompany the form, which will include the fair market value on the date of death and any medical expenses incurred by an individual beneficiary on behalf of the deceased within one year of death. Earnings on the account after the date of death are reported as income. If more than one HSA is inherited in a tax year, a separate Form 8889 is completed for each HSA, plus a summary 8889 combining the accounts.

If the estate is the beneficiary, the value of the HSA as of the date of death is included on the final tax return.