@HSAQuestion1 wrote:
Sorry @Opus 17 I jumped into this thread and probably made it confusing. I am not OP, I just had a different question that was related.
I had $3,850 excess in 2023. Already amended to pay taxes and 6% penalty on that $3,850 in 2023.
In late 2024, I took a distribution of $4,098 for excess + earnings on the $3,850. It should be Code 1 because it was too late to simply withdraw without penalty. I know I have to pay taxes + 20% penalty on the $3,850 to clear Form 5329 going forward, but someone else on this forum said I could avoid paying the taxes + 20% on the earnings of $248 if I claim $248 of medical expenses on Form 8889 Line 15, because I only need the original $3,850 to clear the 2023 excess from Form 5329. This would result in the $248 earnings never being taxed, which I found odd.
Would the earnings wind up somewhere else on the 1040? Or is using the $248 as a qualified medical expense not allowed under these circumstances?
What you read is correct. If you missed the deadline for a proper return of excess contribution (which was October 15, 2024, but only if you filed your return on time or got an extension) then you simply made a normal withdrawal of $4098. (There was no reason to remove the excess contributions after the deadline.)
Since you have a normal withdrawal of $4098, how that is taxed is according to the normal rules. If it is used for qualifying medical expenses, it is not taxed. That's the whole point of an HSA if you follow the rules, money is not taxed going in and not taxed coming out. If you don't use it for qualified expenses, you pay tax and a penalty but that can be used to negate an excess contribution.
Even if you were never eligible in 2023 or 2024, the rules allow this. If you removed the money on time, the interest is taxable as if you earned it in a regular investment, because the HSA contribution "never happened" (in a way). Since you left it too late, you pay the 6%, and then it just becomes money in the account that is eligible to be used for medical expenses.
Of course, you have also now paid tax 3 times on the initial $3850 (once in 2023 because it was not deductible, once in 2024 when you withdraw it not for expenses, and the 20% penalty.)
Let me also remark that if you brought the account to zero (just guessing) the penalty is zero because the penalty is 6% of the excess or the remaining balance, whichever is lower. That means that if you had (for example) $1000 of qualifying expenses, you can declare that, and the first $1000 will be tax and penalty-free, and you would pay income tax and 20% on the remaining $3098 of the withdrawal instead of $3850.
