Your HSA Needs a Succession Plan

If you’ve heard of health savings accounts, it has probably been in the context of their trifecta of tax benefits: pretax money going in, tax-free compounding while the funds are inside the account, and tax-free withdrawals for qualified healthcare expenditures.

But even HSAs have their limits. As I’ve written before, the tax benefits of the accounts effectively cease upon the account owner’s death, or the death of his or her spouse if that person is the beneficiary.

That makes it crucial to have a succession plan for your HSA: a plan to encourage tax-free spending during your lifetime (and your spouse’s, if you have one), as well as naming the correct beneficiary for the account in an effort to maximize the tax benefits.

HSAs Give During Your Lifetime …

Whereas tax-sheltered retirement account owners will pay taxes on the dollars they put into a retirement account (Roth) or on their withdrawals (traditional tax-deferred), HSAs are a unicorn account type in that the funds are tax-free every step of the way, provided you spend the money on qualified healthcare expenses.

Those tax benefits are magnified for people who pay their healthcare expenses out of pocket, invest in long-term investment assets, and are in higher tax brackets. That’s why you often hear that strategy touted for people who have the wherewithal to do so.

Given those prodigious tax benefits, an HSA investor would have a bigger balance than a person investing in an IRA, 401(k), or taxable brokerage account, assuming the same contribution amounts, rates of return, tax rates, and holding periods. That’s because investors in those other account types pay taxes at various points along the way: at time of contribution (Roth), during accumulation (taxable), and/or at time of withdrawal (taxable, traditional tax-deferred).

... And Take After Death

If your spouse is the designated beneficiary of your HSA, the HSA becomes theirs after your death, and the tax benefits continue. They can continue to take tax-free withdrawals for qualified healthcare expenses.

But if a person other than your spouse inherits the HSA, the account is actually less attractive than the other key account types I mentioned before. That’s because an HSA inherited by a nonspouse beneficiary effectively ceases to be an HSA upon the account owner’s death, and all of its tax benefits go away at that time, too. Moreover, the nonspouse will need to include the inherited HSA amount in their income and pay taxes on it.

The tax treatment of an HSA inherited by a nonspouse beneficiary—fully taxable to the beneficiary—is a bit worse than the tax treatment on other major account types that nonspouse beneficiaries might inherit. Heirs enjoy tax-free withdrawals on inherited Roth accounts. Traditional IRA beneficiaries owe taxes, but they at least enjoy some flexibility on the timing of their withdrawals and tax bills. Heirs inheriting taxable accounts have it even better, in that their cost basis becomes whatever the account holdings’ values were on the date of your death.

That’s Why You Need a Plan

That meh tax treatment on HSAs inherited by nonspouse beneficiaries points to the value of having a plan to maximize your HSA’s long-term tax benefits.

That plan consists of three key steps:

Step 1: Get a System for Spending From It

Because spending from the HSA during your and your spouse’s lifetimes is the name of the game, every HSA owner needs a spending plan. That’s true whether you’re paying healthcare expenses as you incur them or investing the funds for retirement.

If you’ve been paying your healthcare costs out of pocket in an effort to allow your account to grow, you can later pull from the account for nonhealthcare expenses, provided you have receipts to substantiate those previous out-of-pocket healthcare costs. Ideally, you’d scan and document those expenditures as you incur them. And if you’re a married person who’s overseeing your household’s HSA, make sure your spouse understands the withdrawal rules, where to find receipts, and how to submit them to the HSA provider.

Step 2: Assign the Correct Beneficiaries

The next step is to give care to naming beneficiaries. If you’re married, your spouse is a sensible beneficiary for the HSA; as noted earlier, your spouse will be able to take over ownership of the account after your death and keep its full tax benefits during his or her lifetime.

Nonspouse beneficiaries won’t receive the same favorable tax treatment. However, if you think a nonspouse beneficiary will benefit from the money in whatever shape that takes, that’s probably a good enough reason to leave them the HSA. But other accounts should take precedence.

A charity can also make an excellent HSA beneficiary, in that the charity won’t need to pay taxes on that amount. That strategy can be particularly appropriate for single people who are charitably inclined, or for surviving spouses. If you’re part of a married couple, consider making your spouse the primary beneficiary and a charity the secondary.

Step 3: Make Sure Your Beneficiaries Understand the Rules About HSAs

If your spouse will inherit your HSA, be sure to underscore the value of liquidating the account during his or her lifetime.

And while it’s generally not advisable for a nonspouse beneficiary to inherit an HSA, if that’s your plan, it’s important to let your loved ones know that they can reduce the taxable amount in the HSA by paying any of your unpaid medical bills from the HSA. They just need to pay those bills out of your HSA within a year of your death.