We know the deal with HSA. The money goes in before any taxes are taken out, it grows tax-free when invested and you can use that money to pay for medical expenses, all tax-free again. As I explain it here, this is the only money in our system that never gets taxed.
Ideal strategy is to not to use the HSA money while you are working and to let the money compound tax-free till your later years. Because the best part about an HSA is that you can save medical receipts during the interim years and retroactively get reimbursed for all your past expenses whenever you choose to.
You can keep this in your backpocket during retirement if your income from other sources is high enough that disallows some of the Affordable Care Act (ACA) tax credits or if your income puts you closer to the Medicare IRMAA thresholds. You can then decide to say curtail withdrawals from your pre-tax IRAs (to reduce your taxable income) and instead bridge the income gap by reimbursing yourself from your HSA. This way, you kind of solve your cash flow needs without realizing any extra taxes and without pushing you above any ACA or Medicare income cliffs, saving you a good deal on insurance premiums.
But with all the good things that come with an HSA, there is one big possible downside and that is the risk of dying with HSA money on your balance sheet. Like any qualified accounts, you need to name a beneficiary for your HSA money and for married people, they would name their spouse which is the right first step.
Because when your spouse inherits your HSA, nothing changes as she can use the HSA funds the same way before or after your death. And HSA funds can be used for any medical expenses in your direct family whether it is for you, your spouse or your child assuming that child is your tax-dependent. That tax-dependency test is really the metric of merit when it comes to who can use your HSA funds for medical bills.
But back to the beneficiary thing and as I said, not a big deal if your spouse is the beneficiary but what if you don’t have a spouse anymore and you leave the HSA money to a non-spouse heir?
Because if a non-spouse heir inherits an HSA, the account ceases to be an HSA on the date of the owner’s death and the entire fair market value is included in the beneficiary’s taxable income for that year. The beneficiary must pay ordinary income tax on the full amount.
So say you got $50,000 in your HSA and you leave it to your son, the entire amount moves to his side of the balance sheet as taxable money all at once in that year. There is no 10-year rule to take money out like you have when inheriting an IRA.
That is a lot of unintended taxable income for your heir and it may entirely negate all the tax benefits you realized from your HSA.
There is one workaround though. The child can pay the deceased person’s medical bills and claim that as a deduction against the HSA he or she inherits, essentially reducing some or all of the taxes the heir would owe when inheriting the HSA. But the caveat is that only the bills the heir pays within one year of death counts towards this offset.
As an example, if someone dies with $50,000 in medical bills and with $50,000 in an HSA, in the worst-case scenario, the hospital bills gets paid by the deceased person’s estate using taxable dollars and the HSA passes to the beneficiary and is all taxed as income to the beneficiary.
In the best case scenario, the hospital bill gets paid by the beneficiary and he or she claims that payment as a tax deduction when filing their return to offset the money they inherited from the HSA. That way, the $50,000 in the estate that could have been used to pay for medical expenses now gets distributed to the heir on a stepped up in cost basis, essentially tax-free.
Ideally, to avoid the tax hassles with passing down HSA money to non-spouse heirs, I’d aggressively start whittling down the money starting say at age 65. And if you have past receipts (you should), you can strategically reimburse yourself to bridge your cash flow needs to avoid crossing over the Medicare IRMAA threshold.
Talk about Medicare, you can use the HSA money for Medicare premiums, you can use the money to pay for most long-term care premiums and costs, you can use the money to pay for Cobra premiums and you can also use the money to pay for some (not all) types of ACA premiums.
Kaiser Family Foundation, a healthcare thinktank, did an analysis that says that the average Medicare beneficiary spent a total of $6,300 on out of pocket healthcare costs each year and that includes the Medicare premiums. HSA, in this case, should be your go to bucket for these kinds of expenses.
But whatever you do, plan your HSA money in such a way that there is nothing left for your heirs to inherit.
Thank you for your time.
Cover image credit – Arina Krasnikova, Pexels