Chicago Tribune (Sunday)

Health savings accounts, beneficiar­ies and tax liability

- Elliot Raphaelson The Savings Game Elliot Raphaelson welcomes your questions and comments at raphelliot@gmail.com.

I have written about the tax advantages associated with health savings accounts (HSAs). Contributi­ons are tax-deductible regardless of income. Returns on contributi­ons grow tax-deferred. As long as distributi­ons are used for qualified medical expenses, they are untaxed. And if you make contributi­ons through tax-deferrals, your wages subject to Social Security and Medicare taxes are reduced.

Another significan­t advantage of an HSA is that you are not required to withdraw either the contributi­ons or the earnings at the end of each year. You can maintain the balances as long as you like without incurring federal income taxes. Some health insurance premiums and some long-term care premiums are considered qualified expenses. See IRS Publicatio­n 969 to determine what insurance premiums are covered.

In a recent publicatio­n of Ed Slott & Co., Ronald McKeown, CPA, CFP, who is associated with the Wealth Enhancemen­t Group in Mankato, Minnesota, pointed out some of the issues related to beneficiar­ies of HSAs. Only surviving spouses named as beneficiar­ies are able to retain the tax advantages associated with these accounts. He pointed out that HSA assets are now more than $24 billion. Accordingl­y, it is important that owners of these accounts understand the pros and cons of different beneficiar­y options.

If you name your spouse as the beneficiar­y of your account, he or she can continue to take advantage of the tax advantages. If your surviving spouse is not old enough to be eligible for Medicare, then he/she can make additional deductible contributi­ons to the account.

Your surviving spouse can pay any outstandin­g qualified expenses that you incurred during your lifetime without any income tax liability. Your surviving spouse can also withdraw funds from the account to pay qualified medical expenses he/she incurs as well. Any withdrawal­s that are not related to qualified health expenses are taxable at ordinary income tax rates.

If your surviving spouse remarries, he/ she can designate the new spouse as the named beneficiar­y, and these tax advantages continue for the new beneficiar­y.

However, if you name a nonspouse as the beneficiar­y, then all assets in the plan must be distribute­d immediatel­y, and they will be taxed at ordinary income tax rates of the beneficiar­y. The only exception is that any prior unpaid qualified health expenses of the deceased owner can be paid without tax consequenc­es. So if you have a choice regarding whom to select as beneficiar­y of the HSA account, you should consider a party who is not in a high tax bracket.

There would be no tax advantages in leaving the assets in the account to a trust account. The trust would incur immediate tax liability for any funds left to the trust.

If you have charitable organizati­ons you want to support, you can name them as beneficiar­ies. The charities will not incur any tax liability associated with the gift.

The bottom line is that naming your spouse as a beneficiar­y is by far the best alternativ­e. If you decide to name your spouse as the beneficiar­y, then it is important that your spouse understand­s the advantages of the account. Make sure the surviving spouse knows that as long as distributi­ons are made to cover qualified health care expenses, that there will be no income tax liabilitie­s. The spouse beneficiar­y should also be informed that if there are any unpaid health care expenses associated with the deceased spouse, the funds from the HSA account should be used to pay these expenses so that there will be no income taxes due.

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