In many ways, the HSA is the most tax-efficient savings vehicle in the financial system. Contributions are deductible. Growth is tax-free. Qualified withdrawals are tax-free. No other account offers all three simultaneously.
That combination has led many disciplined savers to use HSAs very differently than originally intended. Rather than spending the account annually on current healthcare expenses, many investors instead pay medical costs out of pocket and allow the HSA to remain invested for decades.
Over time, what began as a healthcare reimbursement account can become a meaningful retirement asset.
For many households, HSAs now play a broader role inside the financial plan — helping create additional tax-free flexibility for future healthcare costs, Medicare expenses, long-term care needs, and retirement income planning later in life.
At Tidewater Wealth Management, we often help clients evaluate not only how much to contribute to an HSA, but also how the account should be invested, when it makes sense to spend versus preserve the balance, and how the HSA fits into the broader tax and legacy strategy over time.
The challenge is that while HSAs receive incredibly favorable tax treatment during life, the inheritance rules can be surprisingly unfavorable for heirs.
The Key HSA Inheritance Rule
If a surviving spouse inherits the HSA, the account simply becomes their own HSA with no immediate tax consequence.
But for anyone else — children, other family members, or non-spouse heirs — the rules change dramatically.
The inherited account immediately loses its HSA status, and the full account balance becomes taxable income to the beneficiary in the year of death.
There is no ability to stretch distributions over time like an inherited IRA. No rollover into the beneficiary’s own HSA. No long-term deferral strategy.
For beneficiaries already in high earning years, this can create a substantial and unexpected tax burden. A child inheriting a large HSA may suddenly recognize hundreds of thousands of dollars of ordinary income in a single year, potentially pushing them into significantly higher marginal tax brackets.
Importantly, while the normal 20% HSA penalty does not apply to inherited accounts, ordinary income taxes still do.
One Limited Exception
If the decedent had unpaid qualified medical expenses at death, the beneficiary may use HSA assets to pay those expenses within 12 months and reduce the taxable portion of the inheritance accordingly.
While helpful, this provision often does not materially change the broader planning issue for larger accounts.
Why This Matters More Today
What makes this increasingly important is that HSA balances today are often far larger than policymakers originally envisioned. Many investors have spent years maximizing contributions, investing the balance, and intentionally delaying withdrawals. For disciplined savers, HSAs can quietly compound into significant six-figure assets over time.
As a result, beneficiary designations on HSAs now deserve the same level of attention as retirement accounts, trusts, and estate documents.
Planning Considerations
For investors with substantial HSA balances, proactive planning becomes important — particularly when non-spouse beneficiaries are involved.
In some situations, it may make sense to intentionally spend down the HSA during retirement on qualified healthcare expenses rather than leaving the account to heirs. In others, charitable beneficiaries or coordinated withdrawal strategies may create more favorable long-term outcomes.
This is also why HSA planning should not happen in isolation. The decision to preserve or spend HSA assets often intersects with retirement income planning, Medicare strategy, Roth conversions, charitable giving goals, estate planning considerations, and the sequencing of withdrawals across multiple account types.
At Tidewater Wealth Management, we incorporate HSA planning into the broader financial picture — helping clients think through their unique financial plan, not just the investment opportunity during life, but also the long-term tax and legacy implications for the next generation.
Final Thoughts
HSAs remain one of the most attractive planning tools available for eligible investors. But like many tax-efficient strategies, the long-term value often depends on thoughtful coordination and proactive planning.
As balances grow, reviewing how the account is invested, spent, and ultimately passed to heirs becomes increasingly important.
For households that have accumulated meaningful HSA balances, a simple beneficiary review and broader planning conversation can help avoid unintended tax consequences later on.
Spend down the HSA rather than passing it on. The most straightforward approach is to use the HSA for qualified medical expenses during the account holder’s lifetime, reducing the balance available to trigger a tax event at death. This is particularly relevant for account holders who have been accumulating the balance by paying medical expenses out of pocket. Drawing on the HSA for those expenses reduces the inherited balance without cost, since the withdrawals are tax-free.
Use HSA funds for long-term care insurance premiums. Qualified long-term care insurance premiums are eligible HSA expenses up to age-based IRS limits. Using the HSA to pay LTC premiums reduces the taxable inherited balance while providing coverage that has legitimate planning value.
Consider charitable designation. Naming a qualifying charity as beneficiary of the HSA eliminates the income tax at inheritance, since the charity does not pay tax on the proceeds. For account holders with significant charitable intent and a large HSA balance, this can be a more efficient outcome than passing the full taxable amount to a non-spouse heir.
Spread the beneficiary designation across multiple people. Because the taxable amount is income to the beneficiary in the year of death, concentrating the full balance in a single non-spouse beneficiary produces the highest marginal rate impact. Dividing the designation across multiple beneficiaries can reduce the amount each individual must recognize in a single year, potentially keeping each at a lower marginal rate.
Prioritize HSA spending over other account spending in late retirement. Account holders who are weighing which assets to draw first in retirement should generally prioritize HSA spending over traditional IRA or 401(k) distributions when both would be subject to income tax anyway. Spending down the HSA on qualified medical expenses first preserves the tax-deferred accounts, which have more favorable inheritance rules for non-spouse beneficiaries under the 10-year rule.
Next Steps
At Tidewater Wealth Management, we incorporate HSA planning into the broader financial picture — helping clients think through not just the investment opportunity during life, but also the long-term tax and legacy implications for the next generation. The right approach depends on the account holder’s balance, family structure, charitable priorities, and projected spending in retirement.
For households that have accumulated meaningful HSA balances, a simple beneficiary review and broader planning conversation can help avoid unintended tax consequences later on. If you have not recently reviewed the beneficiary designation on your HSA or considered the estate planning implications, that conversation is worth having.
Bill McDonald, CFP®
Senior Partner, Financial Advisor | Tidewater Wealth Management
West Hartford & New Haven, CT | 203-741-8512 | tidewaterwealth.com