Health Savings Accounts are often described as one of the most tax-efficient accounts available, and for good reason. Contributions may be tax-deductible, growth can be tax-deferred, and withdrawals used for qualified medical expenses can come out tax-free. Used well, an HSA can be a powerful tool for managing health care costs in retirement.
But there is one planning issue that does not get discussed nearly enough: an HSA can become surprisingly tax-inefficient when inherited by the wrong beneficiary.
If a spouse inherits an HSA, the rules are relatively favorable. The surviving spouse generally steps into ownership of the account, and the HSA can continue to function as an HSA. But if a child, sibling, friend, or other non-spouse beneficiary inherits the account, the treatment is much harsher. Under IRS rules, the account generally stops being an HSA at death, and the fair market value of the account becomes taxable income to the beneficiary in the year of death. The taxable amount may be reduced by qualified medical expenses of the deceased account owner that the beneficiary pays within one year after death.
That means a well-funded HSA left to an adult child could create a sudden income tax bill. Unlike an inherited IRA, there is no 10-year distribution window. Unlike a Roth IRA, the account does not generally pass income-tax-free. And unlike a regular taxable brokerage account, there is no step-up in basis that wipes away embedded gains.
This does not mean HSAs are bad accounts. Quite the opposite. But it does mean they should be used thoughtfully as part of an estate plan.
For many retirees, the best strategy may be to use the HSA during life for medical expenses, especially later in retirement when health care costs tend to rise. Another planning step is to keep good records of unreimbursed qualified medical expenses. In some cases, those records may help reduce the taxable amount for a non-spouse beneficiary if expenses are paid within the required one-year window.
The bigger lesson is simple: tax efficiency during life is not always the same as tax efficiency after death. HSAs can be excellent planning tools, but if the goal is to leave assets to the next generation, they deserve more attention than they often receive.