Health Savings Accounts: Who is the Beneficiary?

With all the headline news about the non-repeal of the Affordable Care Act, it is easy to overlook (or ignore) some of the tools that are currently available to help middle and low income individuals pay for their health care like contributions to a health savings account.

Take-Away Message: Name a surviving spouse, if possible, as the beneficiary of a Health Savings Account (HSA), not a child or grandchild.  If a non-spouse is named as the HSA beneficiary, anticipate a qualified disclaimer by the named HSA beneficiary to move taxable income away from the beneficiary to a named contingent beneficiary who is in a marginally lower income tax bracket.

Context: We may be seeing more Health Savings Accounts in our client’s portfolios as the years pass if Medicare/Medicaid benefits are curtailed by Congress. Tax deductible contributions made to those  HSA accounts, reducing a current income tax liability, will grow in an income tax-free environment, like an IRA. If the distributions from the HSA are later used for the account owner’s qualified medical expenses, those distributions will be income tax-free, much like a Roth IRA distribution.

HSA Definition: A Health Savings Account permits tax deductible contributions for those taxpayers who are in a high deductible health insurance plan. The contributions to the HSA grow tax free. Distributions from the HSA to pay for qualified medical expenses are not taxable to the account owner. Due to that high deductible health insurance eligibility requirement, not all clients will own or be able to contribute to a HSA. But for those clients that do own a HSA, it is important to have a beneficiary named for that account, particularly if the account is invested to grow over the years with the intent that it will cover qualified medical expenses in old age, such as medical and dental expenses that are not covered by Medicare or Medicaid.  In short, some HSA’s are viewed much like a Roth IRA, where the accumulated funds and growth in those contributions will be stored and used in retirement years.

HSA Beneficiary Designation: As a generalization, there are no limitations imposed on who can be named as a HSA beneficiary, but the income tax consequences to the named beneficiary will vary greatly.

• Surviving Spouse: If the HSA owner’s spouse is named as beneficiary, that produces a good income tax outcome for the survivor. The surviving spouse can maintain the HSA in their own name and continue to access the HSA assets tax-free to pay for their own health and medical expenses. An important distinction is that while the original HSA account owner had to have HSA-eligible high deductible health insurance plan to be able to maintain that HSA,  their surviving spouse-beneficiary does not have that type of health insurance plan in order to be eligible to maintain the prior spouse’s HSA in their own name. [Note, unlike inherited IRAs, there is no option for the surviving spouse to maintain an inherited The ownership of the HSA  must be changed to the surviving spouse’s name.] If the surviving spouse does have a high deductible health insurance that permits their own eligibility for a HSA, the surviving spouse may continue to make their own contributions to what is now their own HSA.
• Non-Spouse Beneficiary: The income tax results are far different if a non-spouse is named as the HSA  beneficiary. The balance of the HSA is taxable to the non-spouse beneficiary as a lump sum in the year of the HSA owner’s death. There is no opportunity to stretch distributions like there currently is with an inherited IRA. One way to reduce this sudden taxable income to the non-spouse beneficiary is for the beneficiary to use a portion of the HSA account to pay the deceased owner’s final qualified medical expenses if those expenses are paid within one year of the HSA owner’s death. If used for that purpose, the amount of that taxable income  received by the non-spouse HSA beneficiary will be reduced to pay the decedent’s final medical bills. Due to the lump sum income tax burden placed on the non-spouse beneficiary, it might be wise for the HSA owner to actually spend down some of the HSA in the payment of their own medical expenses (income tax free to the owner) prior to their death,  as opposed to permitting the HSA to continue to grow tax-free while the owner is alive. In short, some HSA owners tend to treat their HSA like a Roth IRA, enjoying its growth without having to pay income taxes on the investment income, but that practice may just create a bigger income tax problem for their non-spouse beneficiary upon their death. A non-spousal HSA beneficiary might also disclaim a portion of the decedent’s HSA; a qualified disclaimer (within 9 months of the decedent’s death) would have the effect of moving the disclaimed taxable amount of to the HSA’s named contingent beneficiary who might be in a marginally lower income tax bracket than the primary beneficiary, thus minimizing the income tax erosion of the HSA balance when its owner dies.
• Owner’s Estate: Yet another rule applies if there is no designated beneficiary of the deceased owner’s HSA. In that situation, the balance of the HSA is included on the decedent’s final Form 1040 income tax return. If the owner dies early in the calendar year so that there is little reportable income prior to the owner’s death, this might produce a good income tax outcome since the HSA taxable income will be exposed possibly to a lower marginal income tax bracket. Again, qualified disclaimers by the named HSA beneficiaries might ultimately cause the taxable income to be forced into the deceased owner’s estate, and thus be taxed on the decedent’s final Form 1040 tax return if this causes the least amount of income taxes to be paid.

Conclusion: If any of our clients own a HSA we need to make sure that they have a named beneficiary for their account, and we should alert them to the different income tax consequences associated with the identity of their named beneficiary.