Health Savings Accounts: The Good and the Bad

Take-Away: Health Savings Accounts are a great way to cover medical costs, especially in retirement years, as such expenses increase exponentially with age. The problem is when a Health Savings Account is inherited by a non-spouse.

Background: It has been documented that Health Savings Accounts [HSA] increased by 6% in 2020, exceeding 30 million HSA’s now open. More than $24 billion is now held in HSA’s. Apparently millions of HSA owners look at their accounts as long-term wealth accumulation accounts, rather than merely a tax-favored way to pay for current health and medical expenses.

Benefits of HSA’s: Several benefits can be obtained through contributions to a HSA.

(1) Tax Deductible: HSA contributions are tax deductible, regardless of the individual’s income level or whether (or not) the individual takes the standard tax deduction or itemizes his/her income tax deductions.

(2) Tax Deferred: Contributions to the HSA grow income tax deferred.

(3) Tax-Free if Used for Qualifed Expenses: HSA distributions are not subject to income tax if they are used for qualified expenses. A qualified expense is broadly defined in the Regulations. For example, some insurance premiums are covered as well as some long-term care outlays. Distributions not used to pay qualified expenses, will be subject to ordinary income tax and a 20% penalty, unless due to death, disability, or taken when over the age 55 years.

(4) Avoids FICA Withholding: A HSA through an employer as a salary deferral reduces the wage amount that is subject to Social Security and Medicare taxes. The employee does not include the employer HSA contributions in his/her income. The contributions to the HSA are treated as employer contributions, thus avoiding FICA tax withholding.

(5) Tax Deferred Transfer to Surviving Spouse: A surviving spouse can inherit the balance of a HSA and make that account his/her own. If eligible (see below) the survivor can also make deductible contributions to the inherited HSA up to the prevailing contribution limits.

(6) Tax-Free Rollover: A HSA can be rolled over to another HSA, but like a traditional IRA, it is limited to one-per-year, and it is also subject to the 60-day limit on the time for the rollover to be completed.

(7) Fund Traditional IRA: While IRA funds cannot be transferred to a HSA, there is a one-time exception for HSA funds to be transferred to an IRA, which is limited in amount to the individual’s HSA contribution for that year.

(8) Ownership at All Times: There is no ‘use-it-or-lose-it’ rule associated with HSA’s; the contributions always belong to the owner.

Drawbacks to HSA’s: If a non-spouse is the designated beneficiary of a decedent’s HSA, then when the account is inherited, it ceases to be tax-favored. On the owner’s death the account will be immediately transferred to the designated beneficiary which becomes taxable ordinary income to the non-spouse beneficiary.

– Exception: One exception to the ‘immediately taxable’ rule when a non-spouse inherits a HSA is that for up to 12 months after the account owner’s death, qualified but unpaid medical expenses of the deceased owner can be paid from the distributed amount, and if so used to pay those expenses, the amount will not be included in the non-spouse inheritor’s taxable income.

– Planning Tip: If there is no spouse to be named as the designated beneficiary of the decedent’s HSA, consider naming a charity as the HSA designated beneficiary. If there is no designated beneficiary of the HSA, then the account balance will be included in the decedent’s estate as taxable income.

HSA Eligibility: In order to be able to make contributions to a HSA, the HSA owner must meet several eligibility requirements. He/she must: (i) be enrolled in a high deductible health plan (HDHP) in order to contribute; (ii) cannot have other health insurance that is not an HDHP; (iii) cannot be enrolled in Medicare or Tricare; (iv) cannot have received care from the Veteran’s Administration within the last 3 months; and (v) cannot be eligible to be claimed as a dependent on another person’s income tax return.

– High Deductible Health Plan: For 2021, for a single individual, the HDHP minimum deductible is $1,400, with a maximum out-of-pocket expense of $7,000. For a family HDHP, the minimum deductible is $2,800 with a maximum out-of-pocket expense of $14,000.

2021 HSA Contribution Limits: For an Individual who is under the age of 55 years, the maximum contribution is $3,600, and if over that age, the maximum HSA contribution is $4,600. Contributions to a HSA for a family are $7,200 if the individual is under the age of 55 years, and if over that age, the contribution limit increases to $8,200.

Conclusion: As amounts held in HSA’s continue to grow, more attention needs to be given to the identity of the account’s designated beneficiary. If there is no surviving spouse, it may make sense for the HSA owner to actually use the HSA  to pay qualified expenses, as opposed to continuing to treat the HSA as a wealth accumulation vehicle. Those who administer estates should also keep in mind the 12-month rule where tax-free distributions can still be taken (even when owned by the inheritor) to pay the deceased HSA owner’s qualified expenses.