Are HSA funds taxable to heirs

I recently had a client, Emily, come to me in absolute distress. Her father passed unexpectedly, and she was named as the beneficiary of his Health Savings Account. She’d always understood HSAs were incredibly tax-advantaged during his life, but she was terrified of a huge tax bill looming after his death. She’d been told by a friend that inheriting an HSA was a “nightmare” and feared losing a significant portion of the funds. Unfortunately, her father hadn’t updated his beneficiary designations in years, creating an unnecessary layer of complexity and potential cost.

Emily’s situation is common. Many people forget that HSAs, while powerful savings tools, have specific rules governing what happens to those funds upon death. The core issue revolves around the tax treatment, and it’s crucial to understand the distinctions between different scenarios. As an Estate Planning Attorney & CPA with over 35 years of experience, I’ve seen firsthand how proper planning can prevent these kinds of anxieties and preserve assets for your loved ones.

What Happens When Someone Dies With an HSA?

The tax implications depend largely on who inherits the HSA – an individual or an estate. If Emily had been named as a designated beneficiary on her father’s HSA paperwork, the outcome would have been far simpler. A direct designation allows the HSA to pass directly to her, avoiding probate. However, because of the outdated paperwork, her father’s HSA was likely treated as part of his general estate.

When an HSA is part of the estate, it’s as if the funds were simply another asset – like a checking account or stock portfolio – subject to the normal probate process. This means any funds remaining in the HSA are considered part of the taxable estate. However, the tax benefit isn’t entirely lost. The HSA funds will receive a step-up in basis to their fair market value on the date of death, meaning your heirs only pay taxes on the growth above that value. This is where my CPA expertise comes into play, as accurately valuing the HSA is critical to minimizing tax liabilities.

Inherited HSAs and the “Spousal Beneficiary” Rule

The simplest scenario occurs when a spouse is the designated beneficiary. In this case, the HSA essentially becomes their HSA. They can continue to use the funds for qualified medical expenses, maintaining the tax-advantaged status. There’s no immediate tax impact at the time of inheritance. They will be required to follow all the normal HSA contribution and distribution rules going forward.

Non-Spousal Beneficiaries & Tax Implications

For non-spouse beneficiaries like Emily, the tax picture is more complicated. Once the HSA is distributed, the funds are generally taxed as ordinary income. However, there is a potential exception. If the beneficiary continues to use the HSA funds for qualified medical expenses within one year of distribution, those distributions are still tax-free. Documentation is key here – they must have actual receipts for eligible medical expenses.

The Small Estate Affidavit and AB 2016 Considerations

It’s important to remember that if the entire estate (including the HSA) falls under the thresholds for a Small Estate Affidavit (strictly for real property <$69,625, used for timeshares/vacant land) or, for deaths on or after April 1, 2025, qualifies for a 'Petition for Succession' under AB 2016 (Probate Code § 13151) with a primary residence valued up to $750,000, the process can be streamlined. However, to qualify, the decedent's other non-real estate assets (cash, stocks, etc.) must typically remain below the separate $208,850 Small Estate limit. This is a crucial distinction; a Petition requires a Judge's Order, not an Affidavit.

Don’t Forget the Bank Accounts and Cash Threshold

Similarly, if combined ‘probate assets’ (excluding the AB 2016 residence) exceed $208,850 (the threshold effective April 1, 2025), they are subject to formal probate; a Will alone does not allow you to bypass this limit. This means a seemingly ‘small’ HSA could push an estate over that threshold, triggering a much more complex and costly probate process.

Why Updating Beneficiary Designations is Critical

Emily’s case underscores the importance of regularly reviewing and updating your beneficiary designations. It’s not enough to simply have a Will; your HSA (and other accounts) need to specifically name beneficiaries who can inherit the funds directly. This avoids probate, simplifies the process, and minimizes potential tax liabilities. Proper estate planning isn’t about avoiding taxes entirely; it’s about legally minimizing them and ensuring your assets are distributed according to your wishes, efficiently and effectively.

What does a California probate court look for when interpreting testamentary intent?

In California, a last will and testament operates within a probate system that emphasizes intent, clarity, and procedural compliance. When properly drafted, a will does more than distribute property—it creates legally enforceable instructions that guide courts, fiduciaries, and beneficiaries through administration with fewer disputes and less uncertainty.

For California residents, understanding how intent, authority, and compliance interact is one of the most effective ways to protect family harmony and estate integrity. A will that anticipates probate scrutiny is far more likely to be honored as written and far less likely to become the source of unnecessary conflict.

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.