Take-Away: Dying with a large balance in a heath savings account can create a heavy income tax burden if the beneficiary of that inherited health savings account is not the deceased account owner’s spouse.

Background: The amount held in health savings accounts has grown exponentially in the past few years. In 2016 there was about $5.5 billion held in health savings accounts across the country. By 2021 that amount had grown to $34.4 billion.

Surrogate Retirement Account: One explanation for that growth in health savings accounts may be the triple tax benefit that is achieved with a health savings account. Those tax benefits include: (i) tax-deductible contributions for individuals with high-deductible health plans; (ii) tax-free investment growth and income; and (iii) tax-free withdrawals at any time if the withdrawal is used to pay for qualified medical expenses. Because of these tax benefits, many individuals now look at their health savings plan account as a form of supplemental retirement savings due to the  triple tax benefits and the flexibility associated with such account. There is no minimum age requirement to withdraw funds, tax-free, from the health savings account as long as the funds are used to pay for, or reimburse, qualified medical expenses. Nor are there any required minimum distributions with regard to a health savings account, thus enabling the funds held in the account to continue to be invested and grow tax-free for as long as the account owner chooses during their lifetime.

HSA Limiting Conditions: Any distributions from a health savings account that are not used for qualified medical expenses are taxable. In addition, there is a 20% penalty if the health savings account owner uses the distribution for a non-medical expense  while the account owner is then  under the age 65. Accordingly, to gain the full triple-tax-benefit of the health savings account, there must first be qualified medical expenses for the account owner (or their spouse or dependents) to use the funds to pay.

Two HSA Approaches: There are usually two ways for account owners to use their health saving account. One way is the ‘use-it-as-you-go’ approach, which means that distributions are taken from the account every time there is a qualified medical expense to be paid. This approach often results in the health savings  account being emptied each year. The other approach (which is indicative of the surrogate retirement savings account point of view) is the ‘let-it-grow’ approach, where even when the account owner incurs medical costs, those expenses are paid from funds outside the health savings account, thus permitting the funds held in the health savings account to continue to grow and accumulate over time, exploiting the triple-tax-benefits of a health savings account.  It should come as no surprise then that many financial advisors encourage the second, ‘let-it-grow’ approach, particularly when it is currently estimated that a retired couple will need to have saved at least $315,000 at age 65 just to pay for their health care expenses in their retirement years.

‘Let-It-Grow’ HSA Drawback: The risk associated with the ‘let-it-grow’ approach to a health savings account is the ‘too successful’ health saving account which has more funds held in it than the account owner needs to pay for medical expenses during his/her lifetime. While there clearly exists the triple-tax-benefit that arises from the account, the rules then turn punitive if the account owner dies and names someone other than the account owner’s spouse as the account’s beneficiary. As noted earlier, there are no stretch RMD rules that the health savings account beneficiary is able to exploit when the health savings account is inherited. If the beneficiary is the account owner’s surviving spouse, the account will simply be treated as the property of the spouse who inherits it. The problem is when a non-spouse is named as the account beneficiary.

  • Example 1: Ben and Jennifer are married. Ben has a health savings account with a balance of $150,000. Jennifer is named as the beneficiary of Ben’s health savings account. Ben dies leaving his health savings account to Jennifer.
    Jennifer can treat the health savings account as her own and use its funds to pay for her own qualified medical expenses. Jennifer faces no immediate income tax consequence when she inherits Ben’s health savings account.
  • Example 2: Jennifer inherits Ben’s health savings account. Jennifer promptly names their son Alex as the beneficiary of ‘her’ health savings account. Jennifer dies two months after Ben. Alex now inherits the $150,000 in what was at one time Ben’s health savings account. The $150,000 account balance will be included in Alex’s taxable income for the year in which Jennifer dies. There is no stretch distribution option to ease Alex’s income tax burden. This outcome is problematic for Alex since he is already at the 35% marginal federal income tax bracket even before the additional $150,000 reported from the inherited health savings account.
  • Example 3: Jennifer inherits Ben’s health savings account. Jennifer dies shortly after Ben, but without naming a beneficiary of the inherited health savings account.  Because on Jennifer’s death, there is no named beneficiary of ‘Ben’s’ health savings account the health savings account value will be included in Ben’s final income tax return.

Planning Strategies: There are a couple of steps that can be taken to mitigate the harsh taxation of a ‘too successful’ health savings account when the account owner suddenly dies without a spouse as the account beneficiary.

Payment of the Deceased Account Owner’s Final Medical Expenses: A non-spouse who inherits a decedent’s health savings account can reduce the taxable amount that he/she must report as taxable income by paying the deceased account owner’s qualified medical expenses, if those expenses are paid within one year of the account owner’s death. Accordingly, the taxable value of an inherited health savings account can be reduced by way of qualified medical expenses that (i) were incurred before the date of the account owner’s death; and (ii) which are paid by the account beneficiary within one year after the account owner’s death. [IRC 223(f)(8)(B)(ii).] This is something to keep in mind when estate fiduciaries begin to pay the debts of the decedent- the beneficiary of the account must pay the decedent’s qualified medical expenses.

Exception: There is a limitation to this one-year-payment rule, however. This rule applies only to expenses that were incurred but not paid before the account owner’s death. Any amounts that the health savings account owner incurred and paid themselves before death, and thus had ‘available’ to reimburse themselves for while they were still alive, are not excludible by the non-spouse beneficiary. Once the account owner dies, the opportunity to use any expenses that they could have used to reimburse themselves from their health savings account, but did not, disappears.

  • Example 4: Jennifer incurred $45,000 in qualified medical expenses prior to her death. If Alex uses $45,000 of the $150,000 health savings account that he just inherited from his mother to pay her final qualified medical expenses, Alex will only have to report $105,000 in his taxable income for the year, not the full $150,000 account balance.

Reimbursed Qualified Medical Expenses: The only way to distribute health savings account funds tax-free is by using them to pay or reimburse the owner for qualified medical expenses. [IRC 223.] However, the reimbursement rule allows for greater flexibility in the timing of when the qualified medical expenses are incurred by the account owner. As a generalization, any qualified medical expenses that were incurred between the time the health savings account was initially established and the date the account owner dies, which were not previously reimbursed or deducted on the account owner’s Schedule A, are eligible for reimbursement from the health savings account at any time between the date the expense was incurred and the death of the health savings account owner. Therefore, for those health savings account owners who have spent years paying medical expenses with funds outside of their health savings account while permitting their health savings account to continue to grow in value, i.e. the ‘too successful’ health savings account, they can use their unreimbursed medical expenses of the past to justify a tax-free withdrawal from their health savings account at any time, perhaps on their deathbed. [See IRS Notice 2004-50 that describes the extensive record-keeping obligations imposed on the health savings account owner if their intent is to reimburse qualified medical expenses from years earlier in time.]

  • Example 5: Ben started his health savings account in 2008. In 2010, Ben spent $10,000 on dental surgery in 2010. In 2023 Ben takes $10,000 from his health savings account to reimburse himself for his dental surgery expense that he incurred  in 2010. Even though 13 years have elapsed between Ben’s dental surgery in 2010 and his reimbursement distribution in 2023, that distribution can be excluded from Ben’s taxable income because it is a qualified medical expense that (i) occurred after Ben established his health savings account in 2008, and (ii) that expense that Ben incurred in 2010 was neither reimbursed nor deducted by him.
  • Example 6: Ben, age 60, has spent 20+ years savings funds in his health savings account. Ben’s health savings account balance is now  $150,000. Over those 20 years Ben has spent on average $4,000 a year on medical expenses, or a total of $80,000. Ben paid all of his medical expenses out-of-pocket, and he has neither reimbursed himself through health savings account withdrawals, nor has he included these medical expenses as itemized deductions on his filed income tax returns. Ben is diagnosed with liver cancer and his physicians give him only six weeks to live. Because Ben had $80,000 of qualified medical expenses that were previously incurred and paid for by him (but not reimbursed to him, nor reported as tax deductions by him,) Ben can distribute $80,000 tax-free from his health savings account to reimburse himself while he is still alive. The remaining $70,000 held in Ben’s health savings account will pass to Alex, Ben’s son, after Ben’s death, but that amount is taxable to Alex. Since Ben is nearing death, it makes sense for Ben to deplete his health savings account prior to his death through the reimbursement of $80,000, as opposed to letting Ben inherit the full $150,000 as taxable income.

Conclusion: For those individuals who tend to view a health savings account as a surrogate retirement plan account by exploiting its triple-tax benefits, perhaps resulting in a ‘too successful’ health savings account when death is near, there are a couple of strategic steps that can be taken to minimize the tax ‘penalty’ of leaving that ‘too successful’ health savings account balance to a non-spouse beneficiary. Obviously one of the best solutions is to reimburse oneself from their account, prior to death, for previously unreimbursed, not deducted, qualified health expenses paid in the past. But that, in turn, requires maintaining records that show not only that the expense was qualified, but also that it was neither reimbursed nor deducted by the account owner. Just how many health savings account owners want to retain these required records to address dying with a ‘too successful’ health savings account kind of begs the question.