Inherited HSA Rules

A reader writes in, asking:

“After last week’s article discussing the rules for inherited IRAs, I would be interested to hear about the rules for inherited HSA accounts. We have been using my HSA effectively as a ‘third retirement account’ contributing the max each year regardless of likely medical expenses, since we can take no-penalty distributions for any purpose after age 65. So there’s a good chance that the account will outlive me…or even both of us.”

This is an easy one.

There’s no such thing as an inherited HSA — at least not in the sense that there is with an inherited IRA (in which a beneficiary can continue to own the inherited IRA, with its own set of special rules, for many years).

That is, after you die:

• If your spouse is the beneficiary of your HSA, the account just becomes his/her HSA. (That is, it’s not an “inherited HSA.” It’s just a normal HSA, now owned by your surviving spouse.)
• If somebody other than your spouse is the beneficiary of your HSA, the account is no longer an HSA. It just becomes a regular taxable account, and the full value of the account is taxable as income to the beneficiary in the year of your death.*
• If your estate is the beneficiary of your HSA, the account ceases to be an HSA, and the value of the account is included as income on your final tax return.

There are two primary financial planning implications here:

1. If you’re married, name your spouse as the beneficiary of your HSA!
2. It’s a good idea to prioritize spending down this account (to the extent of your qualified medical expenses, and potentially beyond that extent once you reach age 65) rather than retirement accounts, because your children (or other non-spouse heirs) would rather inherit a retirement account than an HSA that immediately becomes fully taxable.

*If, within 1 year of the date of death, your non-spouse beneficiary (other than your estate) pays any of your qualified medical expenses that were incurred before your death, the amount of those expenses is subtracted from the amount that is taxable to the beneficiary.