Are HSA funds taxable to heirs

I had a client, Christine, come to me last month absolutely devastated. Her husband, Mark, had passed unexpectedly. Mark had a sizable Health Savings Account, and she’d assumed it was a simple transfer to her. What she discovered – and what so many people don’t realize – is that HSAs don’t automatically pass like a 401(k) or IRA. Without proper beneficiary designations and a carefully crafted estate plan, those funds can become subject to a significant tax burden. Christine faced potentially owing income tax and a 20% penalty on the entire HSA balance. The cost of this oversight? Tens of thousands of dollars.

The rules surrounding HSA inheritances are complex and often misunderstood. While HSAs offer tremendous tax benefits during your lifetime, those benefits don’t necessarily extend to your heirs in the same way. The key is understanding the difference between a direct beneficiary and a contingent beneficiary, and how that impacts the tax treatment of the account. I’ve been practicing estate planning and as a CPA for over 35 years, and I’ve seen firsthand the consequences of failing to address these details proactively.

What Happens to an HSA Upon Death?

When you pass away, your HSA doesn’t automatically become part of your general estate. Instead, it’s distributed based on the beneficiary designations you’ve filed with the HSA custodian. If you have a designated beneficiary, the funds generally pass directly to that person or entity. This avoids probate, which is a positive. However, it’s what happens next that’s critical.

Is the HSA Inherited as Tax-Free Income?

The tax implications depend entirely on the type of beneficiary. If you designate a spouse as your beneficiary, the HSA will generally continue to function as a tax-advantaged HSA under their name. They can continue to make tax-deductible contributions and use the funds for qualified medical expenses. This is the most straightforward and favorable outcome.

However, if you designate a non-spouse – such as a child, friend, or trust – as your beneficiary, the rules change dramatically. In this scenario, the HSA assets are generally distributed as taxable income to the beneficiary in the year of your death. This means the entire HSA balance is reported as ordinary income on their tax return, and it’s subject to their individual income tax rate. There is also a potential 20% penalty if the beneficiary doesn’t use the funds for qualified medical expenses within a specific timeframe.

What About Trusts as Beneficiaries?

Using a trust as a beneficiary can be a complex maneuver. Many trusts are structured in a way that doesn’t allow them to receive HSA funds directly. If a trust can accept the funds, it’s typically treated as a distribution to the trust beneficiary, and the same taxable income rules apply. Furthermore, the trust’s terms might dictate how the funds are managed and distributed, potentially leading to further complications. It’s essential to ensure the trust language specifically addresses HSA funds and allows for proper management.

The CPA Advantage: Step-Up in Basis and Valuation

As a CPA, I can provide a unique perspective on HSA planning. Understanding the value of the account is crucial for estate tax purposes, even if the estate isn’t large enough to trigger federal estate taxes. Additionally, I can help you accurately calculate the taxable income for your beneficiaries and explore strategies to minimize their tax liability. For instance, proper valuation can impact the overall estate value and potential tax implications. We can also discuss strategies to time distributions to maximize tax benefits.

Navigating AB 2016 and Small Estate Affidavits

It’s also important to remember that the procedures for transferring assets, including HSAs, can vary depending on the size of your estate. For California residents, the Small Estate Affidavit (strictly for real property <$69,625, used for timeshares/vacant land) is a simplified process for estates with limited assets. However, for deaths on or after April 1, 2025, a primary residence valued up to $750,000 qualifies for a 'Petition for Succession' under AB 2016 (Probate Code § 13151). This is a "Petition" that requires a Judge's Order, NOT an "Affidavit." CRITICAL DISTINCTION: Furthermore, to qualify for the AB 2016 process, the decedent's other non-real estate assets (cash, stocks, etc.) must typically remain below the separate $208,850 Small Estate limit. Even if the home qualifies, a large HSA balance could push the total estate value over that threshold, requiring formal probate.

RUFADAA and Digital Asset Access

Finally, don’t overlook the importance of addressing digital assets, including online HSA accounts. Without specific RUFADAA language (Probate Code § 870) in your Trust or Will, service providers like HSA custodians can legally deny your executor access to the account, even with a court order. This can significantly delay the transfer of funds and complicate the estate administration process.

Resources for Asset Management & Transfer

• Property Tax Reassessment: California State Board of Equalization (Prop 19)
  This page details the “Base Year Value Transfer” rules. It explains that heirs can only avoid a property tax reassessment if the inherited home becomes their primary residence and a claim is filed within one year of the date of death.
• Real Estate Probate (AB 2016): California State Controller – Unclaimed Property
  The primary portal for executors and heirs to search for “lost” assets—such as forgotten bank accounts, uncashed dividends, and insurance benefits—that have been remitted to the State of California for safekeeping.
• Small Estate Affidavits: IRS Estate Tax Guidelines
  The authoritative federal resource for estate valuation. It reflects the 2026 exemption increase to $15 million per person established by the One Big Beautiful Bill Act (OBBBA), which is critical for high-net-worth asset planning.
• Federal Estate Tax: FinCEN – Beneficial Ownership Information (BOI)
  The official portal for corporate transparency reporting. While many domestic U.S. LLCs received exemptions in 2025, executors managing foreign-registered entities or specific non-exempt structures must still consult this resource to ensure compliance.
• Unclaimed Assets: California State Controller – Unclaimed Property
  The primary portal for executors and heirs to search for “lost” assets—such as forgotten bank accounts, uncashed dividends, and insurance benefits—that have been remitted to the State of California for safekeeping.
• Business/LLC Compliance: FinCEN – Beneficial Ownership Information (BOI)
  The official portal for corporate transparency reporting. While many domestic U.S. LLCs received exemptions in 2025, executors managing foreign-registered entities or specific non-exempt structures must still consult this resource to ensure compliance.

What makes a California will legally enforceable when it matters most?

In California, a last will and testament is reviewed under probate standards that focus on intent, capacity, and execution. Clear drafting reduces ambiguity, limits misinterpretation, and helps families avoid unnecessary conflict during estate administration.

When a will is drafted with California probate review in mind, it becomes a stabilizing roadmap rather than a source of conflict. Clear intent, proper authority, and compliant execution protect both families and estates.

Resources for Asset Management & Transfer

• Property Tax Reassessment: California State Board of Equalization (Prop 19)
  This page details the “Base Year Value Transfer” rules. It explains that heirs can only avoid a property tax reassessment if the inherited home becomes their primary residence and a claim is filed within one year of the date of death.
• Real Estate Probate (AB 2016): California Probate Code § 13151 (Petition for Succession)
  The specific statute for the AB 2016 process. It outlines the requirements for using a court-approved “Petition” (not an affidavit) to transfer a primary residence worth $750,000 or less (gross value) for deaths occurring after April 1, 2025.
• Small Estate Affidavit: California Probate Code § 13100 (Personal Property)
  Access the statutory language for the “Small Estate Affidavit.” This procedure is strictly for Personal Property (cash, stocks, vehicles) and is limited to estates with a total value of $208,850 or less (effective April 1, 2025).
• Federal Estate Tax: IRS Estate Tax Guidelines
  The authoritative federal resource for estate valuation. It reflects the 2026 exemption increase to $15 million per person established by the One Big Beautiful Bill Act (OBBBA), which is critical for high-net-worth asset planning.
• Unclaimed Assets: California State Controller – Unclaimed Property
  The primary portal for executors and heirs to search for “lost” assets—such as forgotten bank accounts, uncashed dividends, and insurance benefits—that have been remitted to the State of California for safekeeping.
• Business/LLC Compliance: FinCEN – Beneficial Ownership Information (BOI)
  The official portal for corporate transparency reporting. While many domestic U.S. LLCs received exemptions in 2025, executors managing foreign-registered entities or specific non-exempt structures must still consult this resource to ensure compliance.