Health Savings Accounts (HSAs) are a popular tool for managing healthcare expenses due to their triple tax benefits: contributions are tax-deductible, earnings grow tax-deferred, and withdrawals for qualified medical expenses also tax-free.

How to Avoid the HSA Tax Trap An Introduction to the Deathbed Drawdown Strategy

However, the advantages of HSAs can become complicated upon the account holder’s death: if the named beneficiary or next of kin inheriting the money wasn’t married to the account owner at the time of death, they get stuck with a nasty tax bill, and the entire value of the HSA is taxable income to the beneficiary in the year it is inherited.

Unlike with IRAs, there’s no option to defer the income or to spread the impact out over many years. Income from non-spousal inherited IRAs comes in one big, taxable sum.

HSAs are tremendously efficient at helping people pay for qualified medical expenses with tax-free dollars. But they are very tax-inefficient assets to leave to the next generation.

This article explores the “deathbed drawdown” strategy as a proactive approach for individuals with large HSA balances to manage their accounts toward the end of their lives.

The strategy will minimize the tax impact on heirs.

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How Are Inherited HSAs Taxed?

The tax treatment of HSAs varies depending on the relationship of the person inheriting the account to the deceased HSA owner. Spouses receive favorable tax treatment, as do charities. For everyone else, though, inheriting a big HSA can also cause a big tax bill.

Here are the rules for each category of heir:

1. Spousal Beneficiaries

If the beneficiary is the spouse of the deceased, the HSA can be treated as their own HSA.

This transfer is not taxable, and the spouse can continue to use the funds tax-free for qualified medical expenses. The account retains its tax-advantaged status, allowing the surviving spouse to also contribute to it if they meet the eligibility requirements.

2. Non-Spouse Beneficiaries

For non-spouse beneficiaries, including children, siblings, or other relatives, the situation is less favorable.

The account ceases to be an HSA upon the death of the account holder, and the entire fair market value of the HSA becomes taxable income to the beneficiary in the year they inherit it. This could potentially push the beneficiary into a higher tax bracket for that year.

3. Estate as Beneficiary

If no beneficiary is designated or the estate is the beneficiary, the value of the HSA is included in the deceased’s final income tax return.

This situation also results in the funds being fully taxable.

4. Charitable Beneficiaries

If a charity is designated as the beneficiary, the charity receives the funds without any tax implications, as charities are tax-exempt entities.

5. Special Considerations

  • Non-spouse beneficiaries must withdraw the funds and pay the taxes; however, they are not subject to the additional 20% penalty that typically applies to non-qualified distributions from HSAs
  • Non-spouse beneficiaries can reduce the taxable amount by the qualified medical expenses of the deceased that were incurred before death if these are paid within one year after the death.

In summary, while spouses can inherit an HSA with its tax advantages intact, other beneficiaries face significant tax consequences, receiving the account’s value as taxable income.

The Deathbed Drawdown Strategy

Under the deathbed drawdown strategy, the aim in your later years is to spend down the HSA first.

That way, you can preserve  more tax-efficient assets for the next generation. This minimizes the amount you have to leave to the IRS, and maximizes the amount you can leave to the people you love.

So instead of leaving a large HSA balance to your heirs, you may want to spend the money on healthcare expenses (so you still get the benefit of tax-free withdrawals), and secondarily on your retirement living expenses.

These non qualified withdrawals for anything other than medical expenses are taxable as ordinary income. But if you’re over 65+, the usual 20% penalty doesn’t apply. And taking the same amount out of an IRA or 401(k) would also incur the same income tax.

But your heirs would get to spread the tax hit on an inherited IRA over up to 10 years. So it’s much better to name designated beneficiaries on an IRA or 401(k) and leave those assets for the next generation, rather than an HSA.

The Twelve-Month Rule: How Heirs Can Reduce Taxes on an Inherited Non-Spousal HSA

Non-spousal heirs have up to twelve months following the original HSA owner’s death to identify outstanding qualified medical expenses and pay them.

Under IRC Section 223(f)(8)(B)(ii), non-spousal HSA beneficiaries can reduce the taxable value of the HSA by the amount of any qualified medical expenses that have been:

  • Incurred before the date of the decedent’s death; and
  • Paid by the beneficiary within 1 year after the decedent’s death.

Any amounts they pay for qualified medical expenses are deducted from taxable income arising from the HSA.

Example: You inherit a $100,000 HSA when your mother dies. You’re in the 32% tax bracket, so you expect a $32,000 tax hit.

However, a few months later, during the probate process, you learn that your mother still owed a doctor $20,000 for a surgical procedure years ago.

You pay the bill yourself, thereby reducing your taxable income from the inherited HSA by $20,000, and reducing your expected tax hit from $32,000 to ($80,000 x 32%), or $25,600 – saving $7,600.

What Are The Most Tax-Efficient Assets to Leave to Heirs?

The most tax-efficient assets to leave to non-spousal heirs and beneficiaries include those that can minimize or avoid the burden of income, estate, and inheritance taxes.

Any of these assets are generally more tax-efficient to leave to heirs than HSAs. Here are some of the best assets to consider:

  1. Life Insurance. The proceeds from life insurance policies are generally tax-free to the beneficiary. Furthermore, life insurance avoids probate: The death benefit goes right to the beneficiaries (as long as you didn’t name yourself or your estate as your beneficiary!). This makes life insurance an extremely effective tool for transferring wealth without tax implications. It can provide a significant amount of cash to heirs that they can use for any purposes including paying any estate taxes due on other inherited assets.
  2. Roth IRAs. Unlike traditional IRAs, and HSAs, Roth IRAs offer tax-free growth and tax-free withdrawals for both the account owner and the beneficiaries. Since taxes are paid upon contribution, heirs can withdraw the funds tax-free, provided the account has been opened for at least five years. Unlike life insurance death benefits, inherited non-spousal Roth IRAs are subject to RMDs starting at age 72.
  3. Real Estate with Stepped-Up Basis. Real estate can be advantageous if passed to heirs because of the step-up in basis. When the heirs inherit the property, the property’s tax basis is stepped up to its current market value, so if they sell it immediately, they typically won’t owe capital gains tax on the increase in value that occurred during the decedent’s lifetime. If it’s an investment property, depreciation from the rental property may help your heirs offset taxable income from other sources – especially if your heirs have real estate professional status.
  4. Stocks and Securities with Stepped-Up Basis. Similar to real estate, stocks, and other securities benefit from a step-up in basis at the owner’s death. This means the heirs’ basis in these assets is the market value at the time of the owner’s death, potentially reducing capital gains tax if the stocks are sold shortly after inheriting them. Generally, where possible, it’s a good idea to hang on to highly appreciated securities and real estate later in life, rather than pay a large capital gains tax. Why? Because when you die, the capital gains go away, the cost basis is reset to zero, and your heirs have the option of keeping the assets or selling them immediately after your death, when taxable gains would be at or near zero.

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Deathbed Drawdown Tips

Here are some smart tips, approaches, and strategies for executing a deathbed drawdown of a large HSA:

  • Prioritize Medical Expenses. The primary focus should be on using the HSA funds for qualified medical expenses, which are tax-free. This includes past medical expenses that have not yet been reimbursed, as long as there is documentation to support these expenses.
  • Assess the Overall Financial Situation. Consider the total value of the HSA in relation to the entire estate. If the HSA comprises a significant portion of the estate, prioritizing its drawdown might be more critical. This assessment will help in deciding how aggressively to use the HSA funds.
  • Keep careful records. Keep all records, invoices, bills and statements documenting medical expenses over the years. This ensures that in case of an audit, withdrawals from the HSA are not subject to needless taxes and penalties.
  • Reimburse yourself for old medical expenses. There’s no time limit on reimbursing yourself from an HSA for qualified medical expenses. You can go back as far as the day you opened the account to pay yourself back for any medical expense listed as qualified in IRS Publication 502. However, you cannot reimburse yourself tax-free for any medical expenses for which you were reimbursed by insurance or any other source.
  • Update designated beneficiaries. If your original beneficiaries have passed on or are now estranged, it’s time to change them. You should also consider alternate and contingent beneficiaries. Not just on your HSA, but on all your retirement accounts, and annuities, as well. If they are minors, you should establish trusts for them, with reliable trustees to manage these assets on their behalf until they come of age. By updating your beneficiaries, you ensure that the assets go directly to them, bypassing the lengthy and expensive probate process. You also shield these assets from creditors, who have a claim on any assets in your estate during probate, but no claim on assets that pass directly to your beneficiaries.
  • Communicate with Beneficiaries. Inform heirs about the existence of the HSA and the strategy to spend down its balance on medical expenses first. This communication ensures that they are aware of the potential tax implications and can plan accordingly.
  • Create a Springing Power of Attorney. If the HSA owner is incapacitated, having a durable power of attorney in place can allow a trusted individual to manage the drawdown process. This helps in continuing the strategy even if the original account holder cannot make decisions for himself/herself. The term “springing” means that the Power of Attorney document does not become effective until you are declared incapacitated or incompetent to manage your own affairs. Then the Power of Attorney “springs” into effect.
  • Consider Timing and Urgency. If your health is rapidly declining, you might want to accelerate your HSA drawdown. For example you may go back years and reimburse yourself for out-of-pocket medical expenses from your HSA. You should also ensure that current and ongoing medical costs are paid from the HSA, rather than from other assets.

Common HSA Drawdown Mistakes

Here are some of the common mistakes and pitfalls you and your heirs should avoid when a large inherited HSA is a factor:

  1. Not Spending on Qualified Medical Expenses. One of the primary benefits of an HSA is the ability to spend the funds tax-free on qualified medical expenses. A common mistake is neglecting to use HSA funds for these expenses. This can lead to unnecessary tax liabilities for the heirs.
  2. Poor Documentation. Failing to keep detailed records and receipts for medical expenses can be problematic, especially if the IRS requires proof of the expenses for tax-free withdrawals. It’s crucial to maintain organized and accessible records of all medical expenses that justify HSA withdrawals.
  3. Ignoring Timing. Not considering the timing of withdrawals can lead to inefficiencies. For example, reimbursing for old medical expenses can be done tax-free, but it requires having kept receipts and records from the time those expenses were incurred. Delaying these reimbursements until the deathbed can complicate the process.
  4. Lack of Communication. Not informing heirs or involved parties about the HSA and its intended drawdown strategy can lead to confusion and potential mismanagement after the account holder’s death. Clear communication about the existence of the HSA and the strategy for its use is essential.
  5. Neglecting to Plan for Incapacity. If the HSA owner becomes incapacitated, without a power of attorney or similar arrangement in place, it may be difficult for someone else to manage the HSA on their behalf. This can hinder the execution of a planned drawdown strategy.
  6. Overlooking Estate Planning Integration. The HSA should be considered as part of the broader estate plan. Not integrating these plans can lead to oversight where the HSA is not optimally utilized as part of the estate, potentially leading to higher tax burdens for heirs. 


The deathbed drawdown strategy offers a significant opportunity for you to minimize the tax burden on your heirs.

By prioritizing using your HSA funds for qualified medical expenses, particularly towards the end of life, you can ensure that your family inherits the maximum possible amount from your HSA with minimal tax implications.

By being proactive and spending down HSA assets before other more tax-efficient assets,  you can enhance the financial legacy you leave behind, ensuring that your hard-earned savings go to your loved ones, rather than the IRS.

Need help? Have questions? We’re here to help. Simply contact a MediGap Advisors Personal Benefits Manager for a free consultation.

This conversation could save you and your heirs many thousands of dollars in needless income taxes.

Disclosure: HSA For America does not provide individualized tax advice. The information in this article is for general knowledge purposes only, and should not be construed to constitute a personal recommendation.

For information pertaining to your specific circumstances, you should consult a qualified tax professional.

For Further Reading: Is Your Estate Safe From Medicaid? Maybe Not! | Medicare Plans: Choose Your Doctor for More Healthcare Freedom | Medicare Prescription Drug Savings Tips for 2024

Tom Lockwood is a Personal Benefits Manager at MediGap Advisors. Tom has a passion for bringing clarity to those confused about Medicare. He is an authority on Medicare, Medicare supplement plans, Medicare Advantage plans, and Part D prescription drug plans. Read more about Tom on his Bio page.