Why Your Kids Don’t Want Your HSA

Do you have an HSA? Have you thought about what will happen to those funds after you are gone? You may be surprised.

At your death, any funds remaining in your HSA are payable to the beneficiary you name on the account. If your spouse is your beneficiary the news is good. If your kids get your HSA, they may not fare so well.

Your Spouse Can Keep Your HSA

Naming your spouse is a good strategy. If you name your spouse as your HSA beneficiary, at your death your HSA will become your spouse’s own HSA. Your spouse can maintain the HSA in their own name and can continue to access the funds. Distributions for qualified medical expenses will be income tax-free just as they would have been to you. Your spouse does not have to have HSA-eligible health insurance to have the HSA. However, if they do have HSA-eligible health insurance and if they otherwise qualify, they may make contributions to the HSA.

Your Kids Do Not Fare So Well

Things get more complicated if your spouse is not your beneficiary. Maybe your spouse is deceased and now you want to name your kids as your HSA beneficiaries. Be warned! Non-spouse HSA beneficiaries do not fare very well. The account value of your HSA account becomes taxable to your children in the year of your death. This means that your children will need to include all the HSA funds in their income in one year. They may not use the funds for their own medical expenses. There are no inherited HSA accounts. This means there is no stretch available for HSAs.

If your children are in high tax brackets, the requirement of a lump sum distribution means your HSA assets could be gobbled up by taxes. Uncle Sam may end up with more than your kids. That certainly is not a great outcome.

How can you avoid this? To avoid losing your HSA to taxes, if your spouse is not your beneficiary, you may want to consider being more open to taking tax-free distributions from your HSA during your own lifetime whenever possible to pay for medical expenses. Remember, you can even reimburse yourself for qualified medical expenses you paid out of pocket in previous years as long as those expenses occurred after you established the HSA and you have proof of those expenses. This may be the most tax efficient way to distribute the remaining balance in the HSA.  

By using your HSA during your lifetime you can preserve other assets for your children. They would fare better from a tax perspective inheriting your Roth IRA or even your Traditional IRA. With those assets, unlike the inherited HSA, they could use the stretch.