Chicago Tribune (Sunday)
Health savings accounts, beneficiaries and tax liability
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.