Q: “What happens to the money in a health savings account when the account owner dies?”–James McKay
A: It's up to you to decide.
But let's back up a step: A health savings account offers those in high-deductible health insurance plans the opportunity to save pretax dollars and tap them tax-free to pay for qualified medical expenses, with unused funds rolling over from year to year. Unlike a Flexible Spending Account, you have the opportunity to invest the money. And once you hit age 65, the money can be used for any purpose without penalty—though you will pay income tax, similar to a traditional IRA. So for many people, an HSA also functions as a backup retirement account.
When you open an HSA, you will be asked to designate a beneficiary who will receive the account at the time of your death. You can change the beneficiary or beneficiaries any time during your lifetime, though some states require your to have your spouse’s consent.
Your choice of beneficiary makes a big difference in how the account will be treated after you're gone.
If you name your spouse, the account remains an HSA, and your partner will become the owner. He or she can use the money tax-free to pay for qualified healthcare expenses, even if not enrolled in a high-deductible health plan, says Todd Berkley, president of HSA Consulting Services. Should your spouse be younger than 65, take a distribution of funds and use them for something other than medical expenses, however, he or she will pay a 20% penalty tax on the amount withdrawn plus income taxes (a rule that also applies to you while you're alive).
Thus, Berkley warns against a spouse taking a full distribution to close the HSA. He says that it's better to leave money in the account first for medical expenses, then later for retirement expenses both medical and non—since your partner gets the same perk of penalty-free withdrawals for other expenses after turning 65.
When the beneficiary is not your spouse, the HSA ends on the date of your death. Your heir receives a distribution and the fair-market value becomes taxable income to the beneficiary—though the taxable amount can be reduced by any qualified medical expenses incurred by the decreased that are then paid by the beneficiary within a year of the death.
Failure to name a beneficiary at all means the assets in your account will be distributed to your estate and included on your final income tax return.