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The New Asset on the Estate Planners' Checklist

By John T. Bannen and Kristin A. Occhetti

Probate & Property Magazine: November/December 2009, Volume 23, Number 6

Real Property|Trust & Estate

John T. Bannen is a partner and Kristin A. Occhetti an associate in the Milwaukee, Wisconsin, office of Quarles & Brady LLP.

Until recently, a client's health insurance posed few issues for the estate planning lawyer. But as the federal government struggles with health care reform and as various pre-tax health savings plans have proliferated, the estate planner has a variety of issues to address. Health savings accounts (HSAs) are available for employees who participate in high-deductible health plans (HDHPs). As employers seek to control health insurance costs, these plans are gaining popularity at an exponential rate. According to the U.S. Department of the Treasury, only 438,000 individuals were covered by HDHPs in 2004. Today, that number has increased to 3.2 million and is projected to rise to between 14 million and 21 million by 2010. Although HDHPs have lower premiums, their popularity is also because of the public's increasing awareness of the substantial tax benefits of the HSA. Still early in their development, HSAs were created in 2004 as part of the Medicare Prescription Drug Improvement and Modernization Act, Pub. L. No. 108-173, 117 Stat. 2006, in response to the increasing costs of health care. As such, they are designed to give an incentive to the consumer to control his or her own health care costs. Unlike flexible savings accounts, HSAs do not have a "use-it-or-lose-it" functionality; account holders can carry over balances from year to year until the account holder's date of death or, with proper planning, until the account holder's spouse's date of death.

The basic concept that controls the HSA is tax-focused: all contributions to, distributions from, and income earned in the account occur on a federal income tax-free basis, as long as the assets are used to pay for qualified medical expenses (note that state tax treatment of HSAs varies from state to state). As the wave of HSAs sweeps across the health care landscape, it is important for estate planners to be conversant with the basic operations of HSAs and the attendant estate planning implications of the accounts, which, if not addressed properly, can provide surprising and unfavorable results. This article will first discuss the basic components of HSAs and then turn to the unexposed estate planning issues raised by HSAs for which each lawyer in the practice should prepare.

Establishing an HSA

HSAs are established as tax-exempt trusts or custodial accounts and, as such, are, in a contractual sense, a creature of state law. Like IRAs, HSAs can be set up with a variety of preapproved sponsors, including banks, credit unions, insurance companies, and brokerage houses. The specific details about initial contributions, minimum deposits and balances, and investment options, however, can vary from sponsor to sponsor. HSAs can be invested in any assets that would be permitted as an IRA investment, including bank accounts, money markets, certificates of deposit, and mutual funds. Any income earned by the HSA is not included in gross income, though again state income tax rules may vary. To qualify as an HSA, the "written governing instrument creating the trust" must meet the following requirements:

1. contributions to the account can be only in cash (except in the case of a rollover contribution);

2. contributions cannot be in excess of the maximum deductible contribution for that calendar year;

3. the account must be established with a qualified custodian or trustee (that is, an insurance company, bank, or any other person approved to be a trustee or custodian of IRAs, under Treas. Reg. § 1.408-2(e));

4. the trust assets can not be invested in life insurance contracts;

5. the trust assets cannot be commingled with any other property, except in a common trust fund or common investment fund; and

6. the individual establishing the account must have a nonforfeitable interest in the account.

Code § 223(d)(1). An individual can establish an HSA at any time on or after the date he or she becomes an eligible individual.

Eligible Individuals—Who Can Establish an HSA?

Only "eligible individuals" can establish an HSA. Code § 223(c)(1). To be an eligible individual, the person must be covered by an HDHP on the first day of such month, and he or she cannot be covered by any other type of health insurance that is not an HDHP. In addition, the individual cannot be enrolled in Medicare or be claimed as a dependent on another individual's tax return (thus, the dependent child of a parent may not create his or her own HSA). The Internal Revenue Code distinguishes between two types of HDHPs: self-only coverage and family coverage. Code § 223(c). Self-only coverage covers only the eligible individual establishing the account, but family coverage covers the eligible individual plus at least one other individual, such as a child or spouse, who need not himself be an eligible individual.

For a health insurance plan to be considered an HDHP, the plan must provide for certain higher than customary thresholds for deductibles and out-of-pocket expenses (indexed for inflation), and the plan may not provide benefits for any year until the deductible for that year is met. For the year 2009, self-only coverage must have an annual deductible of at least $1,150, and annual out-of-pocket expenses that the insured must pay for covered benefits, including the annual deductible, co-payments, and other amounts other than premiums, cannot exceed $5,800. Family coverage must have an annual deductible of at least $2,300 and annual out-of-pocket expenses cannot exceed $11,600. Code § 223(c)(2).

Other coverage for certain forms of "preventative care" or "permitted insurance" will not impede an individual's eligibility. For instance, an HDHP does not need to have a deductible for preventative care or screenings, for example, annual physicals, mammograms, Pap smears, and certain preventative drugs or medications, and an individual is permitted to have coverage for liabilities associated with worker's compensation, tort claims, automobile, homeowners, or other property insurance, insurance for a specific disease, or to provide a fixed payment for hospitalization, and coverage for accidents, disability, dental, vision, or long-term care. Code § 223(c)(2)(C), 223(c)(1)(B), 223(c)(3).

Contribution Limits to HSAs

The contribution rules for the first year in which an individual becomes eligible can be complicated; contribution limits are dependent on when the individual became eligible during the initial year and how long the individual continues to be eligible after the initial year's contribution is made. Technically, contribution limits are calculated on a monthly basis based on the statutory limits imposed by the Internal Revenue Code. The statutory annual contribution limits in 2009 for an eligible individual with self-only coverage and an eligible individual with family coverage are $3,000 and $5,950, respectively. If an eligible individual switches types of HDHP coverage during the year, or otherwise enrolls in an HDHP during the course of the taxable year, the full contribution limit is the greater of the sum of the monthly contribution limits in which the individual was an actual eligible individual or the full statutory contribution limit.

But, if the individual is enrolled in an HDHP by the first day of the last month of the individual's taxable year (December 1 for calendar year taxpayers), then the individual will be considered to have been an eligible individual for the entire tax year and will be able to make the full statutory contribution for that tax year. In this instance, if an individual contributes the full statutory contribution, the individual must remain eligible until the last day of the 12th month following the last month of the taxable year for which the individual made the contribution, for example, December 31 of the following year for a calendar year taxpayer. Ceasing to be an eligible individual during this testing period will cause the contribution to be included in the individual's gross income in the year that the individual ceased being eligible to the extent the amount contributed exceeds the sum of the monthly contribution limits. The amount included also will be subject to an additional 10% penalty tax unless the individual ceased being eligible by reason of disability or death. Code § 223(b)(8).

Contributions in excess of the annual contribution limit are subject to an excise tax of 6% and are included in the eligible individual's gross income. The excise tax, however, can be avoided if the excess contribution and the net income attributable to the excess amount are paid to the eligible individual before the filing deadline for his or her federal income tax return for that year. Code § 223(f)(3).

Example 1: Individual H, a calendar year taxpayer, enrolls in self-only HDHP coverage on June 1, 2009, and becomes an eligible individual on that date. H contributes $3,000 to an HSA on July 1, 2009. H drops his HDHP coverage and ceases to be an eligible individual on February 1, 2010. Because H is an eligible individual with self-only coverage on December 1, 2009, he is able to make the full statutory contribution limit of $3,000. The sum of his monthly contribution limits in which he actually has coverage is $1,749.99 (7/12 × $3,000). The testing period for 2009 HSA contributions ends on December 31, 2010. In 2010, because H ceased being an eligible individual during the testing period, H must include in gross income $1,250.01, the amount contributed minus the sum of the monthly contribution limits ($3,000 - $1,749.99). In addition, a 10% additional penalty tax ($125) applies to the amount. I.R.S. Notice 2008-52, ex. 9.

Eligible individuals who have attained the age of 55 within the taxable year are able to make an additional "catch-up" contribution of $1,000. Code § 223(b)(3). Once an individual becomes enrolled in Medicare, however, he or she can no longer make any type of contribution (regular or catch-up) to his or her HSA. Catch-up contributions are calculated monthly for purposes of determining the amount included in gross income of the eligible individual who ceases to be eligible during the applicable testing period.

Contributions can take the form of rollovers. An individual may roll over assets from one HSA to another, limited to one rollover in any one-year period, and the rollover amount is not subject to the contribution limits. I.R.S. Notice 2004-50; I.R.S. Notice 2004-2. An HSA also can receive a one-time tax-free rollover distribution from the eligible individual's IRA if the rollover is contributed in a direct trustee-to-trustee transfer and is not made from a SEP or SIMPLE IRA. Unlike an HSA rollover, an IRA rollover is subject to the contribution limits. Although an individual may elect only one lifetime IRA rollover, if the rollover is made during a month when the individual is enrolled in self-only coverage, and the individual later enrolls in family coverage during the same tax year, the individual is able to make an additional rollover from his or her IRA to maximize the annual contribution limit. But, if the individual fails to remain an eligible individual for 12 months after the rollover transfer, the amount of the rollover is included in the individual's gross income and is subject to a 10% penalty tax on the amount included.

Deductibility of Contributions

HSA contributions are "above-the-line" income tax deductions in computing the eligible individual's adjusted gross income and thus are able to be used, regardless of whether the eligible individual itemizes deductions. Generally, contributions can be made at any time in any amount (subject to permitted maximum) before April 15 following the tax year to which the contributions relate without extensions. Contributions cannot also be deducted as medical expense deductions under Code § 213.

Any person, for example, family members, friends, and employers, can contribute to an HSA on behalf of the eligible individual, but such contributions are deductible only by the eligible individual for whom the HSA was established. Any amount contributed by a person other than the eligible individual or his or her employer is a gift subject to the usual gift tax rules.

Distributions from HSAs

Unlike the contribution rules, distributions from HSAs are not dependent on the individual's eligibility, because at the time the funds are vested, an individual is free to take distributions from his or her HSA at any time. Distributions are excludable from the gross income of the beneficiary, however, only if the amounts are used to pay for qualified medical expenses. Code § 223(d)(1). The term "qualified medical expenses" broadly includes any expenses paid by the individual for medical care, but only to the extent the expenses are not covered by health insurance or otherwise reimbursed. Generally, health insurance premiums are not considered qualified medical expenses for HSA reimbursement unless the individual is collecting federal or state unemployment benefits, has COBRA continuation coverage through his or her employer, or is enrolled in Medicare. IRS Notice 2004-2. Once an individual attains age 65, he or she can use HSA assets to pay for Medicare Part A, B, D, and HMO premiums, co-pays, deductibles, and co-insurance. Medicare supplemental insurance and "Medigap" policies are not qualified medical expenses, and the Code § 213(d)(10) limits do apply to the deductibility of eligible long-term care premiums.

Although the medical expenses must be incurred after the establishment of the HSA, there is no outside limit on the time period during which eligible expenses must be reimbursed. Thus, so long as the medical expenses were incurred after the establishment of the HSA, the reimbursement of the expenses can be delayed and paid at the discretion of the individual. IRS Notice 2004-50.

A great advantage of HSA distributions is that an individual can withdraw funds for payment of medical expenses not only for him- or herself but also on behalf of the individual's spouse or dependents, regardless of whether the individual is enrolled in a self-only or family coverage. Note, however, that the medical expenses paid from the HSA on behalf of a spouse or child may not be eligible to be paid from any other insurance coverage, for example, from the spouse's health insurance policy.

The amount of any withdrawal that is not used exclusively for qualified medical expenses is included in the gross income of the eligible individual and is also subject to a 10% penalty tax unless the distributions are because of the individual's disability or death. Code § 223(f)(4). Interestingly, once an individual reaches age 65, he or she may use distributions for any purposes (such as general retirement income) without incurring the 10% penalty tax. Thus, the HSA acts like a tax deductible, penalty-free retirement account to the extent not needed for payment of eligible medical expenses.

Example 2: Same facts as Example 1, except that on February 2, 2010, H withdraws $1,308.33 from his HSA. The distribution is not used for qualified medical expenses. Therefore, $1,308.33 is also included in H's gross income and is also subject to a 10% penalty tax. As a result, H includes $2,558.34 in gross income ($1,308.33 + $1,250.01 from Example 1) and an additional 10% penalty tax of $255.83 ($130.83 + $125 from Example 1). IRS Notice 2008-52, ex. 9.

Thus, HSAs can provide many tax advantages and planning opportunities. Essentially, the taxpayer who is in a high income tax bracket in his or her working years can leave the HSA account untouched, letting the income accumulate year after year, and use the funds after retirement to pay for Medicare premiums or long-term care premiums so long as they would be eligible for the medical expense deduction. Moreover, the accumulation of the earnings is leveraged by the deductibility of the HSA contributions. Consequently, the HSA, as a practical matter, replaces the deductible IRA account that all taxpayers briefly enjoyed during the Reagan tax years. In fact, the HSA is referred to by some financial planners as a "medical IRA" account.

Estate Planning Considerations

As a result of the 2004 HSA legislation, Congress has created a new asset that estate planners need to incorporate into their practices and coordinate with their client's estate plans. But the income tax consequences of HSA accounts on the death of the eligible individual are largely unexplored or unknown by many estate planners at this time. The popularity of the HSA, driven in part by the deductibility of the contributions, increases the likelihood that more HSAs will be appearing on the asset summary of estate planning questionnaires. Depending on the amount contributed and distributed from the account, and how long the account has been established, HSA balances could be substantial. As such, estate planning for HSAs should merit the planner's attention.

Like retirement plans, the selection and naming of proper beneficiaries can provide continued tax benefits, and choosing the wrong beneficiaries can accelerate income taxation. As is the case with IRAs, the HSA rules are applied without regard to community property laws. Code § 223(d)(4). If the eligible individual names his or her surviving spouse as the beneficiary, then the account may continue as an HSA for the benefit of the surviving spouse. Essentially, as in a spousal rollover IRA, the HSA becomes the surviving spouse's HSA, and the surviving spouse will be subject to income tax only to the extent distributions are not used for qualified medical expenses.

Example 3: H at the time of his death maintained an HSA account with a $10,000 balance. H named W, his surviving spouse, as beneficiary. W can roll over the HSA account to an account of her own and use the HSA account to pay her qualified medical expenses free of income tax.

Should the surviving spouse wish to make additional contributions to the HSA, the surviving spouse would need to be an eligible individual. The HSA is included as an asset in the deceased individual's gross estate, but if the account is payable to the surviving spouse, the payment will be eligible for the federal estate tax marital deduction. The surviving spouse also can exclude from his or her gross income any amounts withdrawn from the HSA for expenses incurred by the individual before his or her death, provided the funds are used to pay for qualified medical expenses. Code § 223(f)(8).

Problems can arise if someone other than the surviving spouse is designated as the account beneficiary or if there is no beneficiary designation at all. If a person other than the surviving spouse is named, for example, a child or the individual's revocable trust, the account will cease being an HSA on the individual's death. As a result, the fair market value of the HSA assets as of the individual's date of death are included in the beneficiary's gross income in the taxable year that contains the individual's date of death. The beneficiary, however, can deduct from the amount includible any funds used within one year of the individual's date of death to pay for qualified medical expenses incurred by the individual before his or her death. To avoid any double taxation of the assets, the beneficiary can claim a Code § 691(c) deduction for any federal estate tax paid and attributable to the HSA that he or she eventually includes in taxable income.

Example 4: S is a single individual who at the time of his death maintained an HSA account with a balance of $10,000. S made the account payable to his two children in equal shares. S dies in 2009. Each of S's children must include $5,000 on their 2009 income tax returns, but they may reduce this amount by any medical expenses incurred by S before his death but which the children pay within one year of S's death.

If no beneficiary is designated the HSA agreement will likely provide that the beneficiary of the account is the individual's estate. When an HSA is payable to the estate, regardless of whether the surviving spouse may ultimately take possession of the HSA through intestacy laws or the eligible individual's estate plan, the date-of-death value of the HSA assets are included on the decedent's final income tax return. The same result occurs if the HSA assets paid to the estate ultimately pass to children or more remote beneficiaries.

Example 5: H maintained an HSA account that at the time of his death had a balance of $10,000. H either did not complete a beneficiary form for the HSA or did complete a form and named his estate as beneficiary. The result is that the funds are collected by his estate. The entire amount of the HSA account will be included in H's final individual income tax return. This is true regardless of whether H's estate, including the HSA assets, eventually passes to his spouse, his children, or some more remote beneficiary.

Thus, as is the case with retirement plans, the selection and designation of proper account beneficiaries of the eligible individual's HSA can have a substantial effect on income tax liability and will control whether there will be a permitted continuation of the HSA if there is a surviving spouse. Under normal circumstances, naming the surviving spouse would be the most advantageous course. Naming a spouse delays the ultimate recognition of income from the HSA account and allows the surviving spouse to continue the tax deferred buildup available in the account.

If there is no surviving spouse, however, a nonspouse beneficiary has the potential advantage of deducting any distributions for the eligible individual's qualified medical expenses within one year of death (note that these income tax deductions will probably be lost unless the HSA beneficiary pays them, because only the beneficiary's payment of the medical expenses is not subject to the 7.5% adjusted gross income threshold). More importantly, an individual who is not survived by a spouse, or a surviving spouse with a spousal rollover HSA, can choose who will incur the income tax liability of the HSA on his or her death, for example, either the estate or the nonspouse beneficiary. To minimize this potential tax liability, as with retirement benefits, HSA owners may wish to consider naming a charitable beneficiary or name a low-income tax bracket beneficiary to receive the taxable income that is accelerated by death.

Consequently, careful naming and review of HSA beneficiaries needs to be added to the estate planner's checklist and reviewed periodically. The estate planner is ideally situated to coordinate and plan for the optimum passage of HSA balances at death. Neither the client nor the financial institution sponsoring the HSA is likely to appreciate the estate planning implications of the account.

Recommending HSAs to Clients

Because of the significant tax advantages an HSA has to offer, not to mention the possibility of lower health care insurance premiums, the topic of HSAs and HDHPs will come up in the natural course of estate planning discussions. Although the estate planner will not typically make specific recommendations regarding health insurance options, knowledge of HSA rules and benefits can be part of the value that an estate planner adds to his clients' general financial health.

The most obvious candidates for HSAs are the young and the healthy. Such clients enjoy (1) lower ongoing health insurance premiums, (2) lower income taxes because of the deductible HSA contribution, and (3) the tax-free compounding of HSA account income over time. Clients with ongoing or chronic medical conditions, however, can still benefit from HDHP/HSAs if the out-of-pocket expenses of monthly prescriptions are less than the amount saved from HDHP premiums. Note, if the payment of medical expenses would otherwise be nondeductible (such expenses usually are under the 7.5% adjusted gross income floor for deduction), paying medical expenses through an HSA, even if the funds never accumulate, makes the payment of these funds essentially deductible. Thus, merely passing the payments through an HSA makes medical expenses barred by the 7.5% adjusted gross income floor deductible. Clients who are nearing retirement age can also benefit from the availability of the annual $1,000 catch-up contributions and the ability to use HSA assets to pay for post-retirement Medicare premiums and deductible long-term care insurance premiums. Should uninsured long-term care expenses be incurred, the HSA funds function as an additional long-term care insurance benefit.

Proper use of HSA accounts requires a thoughtful analysis of the timing and magnitude of the eligible individual's future medical expenses. In addition, without a surviving spouse to designate as beneficiary of the HSA, the taxation of any HSA assets remaining at the death of a single individual will be fully taxable to someone, either the eligible individual (if the estate is chosen as the beneficiary) or to one or more named nonspouse beneficiaries. This is an important difference between HSA plans and retirement plans. Thus, the best strategy may be to plan to use the HSA assets to pay medical expenses during the life of the eligible individual or his or her surviving spouse. Alternatively, if the eligible individual's year of death tax return is in a lower bracket than the potentially named nonspouse beneficiary, payment to the decedent's estate can produce the lowest income tax and, hence, maximize assets passing to the family. For optimum postmortem flexibility, naming the estate as a contingent beneficiary in anticipation of a timely post-death disclaimer by the primary nonspouse beneficiary would allow the beneficiary to effectively choose the lowest tax bracket for recognition of post-death HSA benefits.

Conclusion

In an environment in which a multitude of financial planners and consultants compete for providing what the public broadly perceives as estate planning services, it behooves the estate planning lawyer to be conversant and technically competent in a wide range of issues confronting their estate planning clients. HSAs and HDHPs are the newest addition to the required skill set of the estate planning lawyer. Moreover, the estate planner's familiarity with benefits and limitations of retirement plan distribution rules, the imaginative use of beneficiary designations and disclaimers, and the knowledge of the income tax issues that surround the taxation of income as a result of a client's death makes the estate planning lawyer the most competent and perhaps the only member of the estate planning team capable of fully exploiting the planning potential of HSA accounts on death of the eligible account holder.

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