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How Health Savings Accounts Can Backfire

Ashlea Ebeling 10.13.2017 | Forbes

 

A dentist reader who turned 65 last year has managed to save $220,000 in a health savings account that’s generating $13,000 a year in dividend income. His current plan: “leave it alone and let his daughter deal with it” when he passes. That plan could be a big mistake. Here’s why.

I ran the anecdote by Scott Ditman, a partner and CPA with Berdon LLP. His message to super HSA savers like the dentist: “More power to you. Just be careful. You could end up getting whipsawed on this thing.”

If you leave a health savings account to a non-spouse heir, it becomes taxable income to the heir in the year of your death. So, in our dentist example, his daughter could be hit with $220,000-plus of taxable income in the year of his death. “You could lose half of it to income taxes if it goes to the daughter,” Ditman says.

Instead, if dad spends down the health savings account for out-of-pocket healthcare expenses in retirement (including Medicare and long-term-care premiums, dental work, and caregiving costs, for example), the money comes out tax free.

The main reason to set up a health savings account in the first place is because you get a tax break for putting money in it. If you have an account through your employer you fund it with pre-tax dollars; if you contribute to one on your own, your contributions are tax deductible. (In either case, you can only open an HSA if you have a high-deductible health plan. The contributions limits for 2017 are $3,400 for an individual and $6,750 for family coverage.) Put money in, and even if you pull it right out to cover healthcare expenses, you’ve come out ahead because any money you pull out to cover out-of-pocket healthcare expenses comes out tax-free.

Another perk of HSAs is that money you leave in the account grows tax-free. Once you save enough, you can invest it. HSAs with investments (beyond cash) account for 19% of total HSA assets as of year-end 2016, according to the Employee Benefit Research Institute. Of the HSAs opened back in 2005, 11% are invested, with average balances of $31,239.

It makes sense to use an HSA as a triple-tax-advantaged savings vehicle, but at some point, you should look at spending it down, Ditman says. There’s no deadline for submitting old receipts for out-of-pocket expenses. Keep in mind: If you leave the account to a spouse, your spouse steps into your shoes and enjoys all the same tax benefits during his or her lifetime that you did.

There’s more to consider with a non-spouse heir. What if dad lives in income-tax-free Florida and she lives in high-tax New York? What if he’s retired and she’s a high earner? It might pay for him to take out money without having medical expenses to cover and pay income tax at his tax rate, Ditman says. Non-healthcare-related withdrawals are subject to income tax and a 20% penalty before age 65; once you hit 65, you face the income tax hit but no penalty for non-medical withdrawals.

How does an HSA compare to a traditional Individual Retirement Account? If you leave your daughter a traditional IRA, she could stretch out required payouts over her lifetime, extending tax-deferred growth and softening the income tax blow.

One more consideration: if you’re in estate tax territory, the HSA balance will be included in the assets that make up your estate.

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