Tax Consequences of Inherited Health Savings Accounts
By Ryan Beadle
The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 added health savings accounts (HSAs) to the Code effective for taxable years beginning after December 31, 2003. The rules for inheriting an HSA are different than for IRAs and other tax-deferred retirement accounts, and therefore may be unfamiliar to many given that HSAs are a relatively new concept and very few have been inherited. Under §223(f)(8)(B)(i) of the Internal Revenue Code:
If the HSA account owner’s surviving spouse is the designated beneficiary of the HSA, §223(f)(8)(A) specifies that the HSA becomes the HSA of the surviving spouse and is excluded from income. This is similar to a spousal rollover of an IRA or other tax-deferred retirement account. No other “rollover” is permitted for HSAs.
If the account is acquired by the owner’s estate, the HSA ceases to be an HSA at the account owner’s death, and the account’s value must be included in the account owner’s income for his or her last taxable year.
If the account is acquired by anyone other than the owner’s surviving spouse or estate, then the HSA ceases to be an HSA at the account owner’s death, and the person acquiring the HSA must include the fair market value of the HSA as of the date of death in income in the taxable year that includes the date of the account owner’s death.
There is a provision to reduce the includible income by the deceased HSA account owner’s qualified medical expenses paid by the HSA recipient (other than the spouse or estate) within one year after the account owner’s death. There is also a provision allowing a deduction for increased estate taxes attributable to an item which is also taxable income. §223(f)(8)(B)(ii).
This is a different rule than for an IRA or other tax-deferred retirement account of which the estate is the beneficiary—for retirement accounts, normally the estate includes the item of income on its tax return, and the estate passes that income, and the tax obligation, out to the beneficiaries of the estate, thus taxing the income at the beneficiary’s (usually) lower rates, depending on how many beneficiaries there are and what their marginal income tax rates are.