Based on the amount on line 9 of your 2016 Form 8889 and your indication that the sum of the contributions was $6,499.84, I assume that the code W amount was $6,499.84 - $166.66 = $6,333.18. But how much was actually withheld from your paycheck for deposit into the HSA for 2016? Were these contributions separately identified payroll deductions, contributions made by your employer without being shown as payroll deductions, or were these contributions from a larger a payroll deduction for healthcare coverage in general?
1. If the $166.66 refund to you plus interest and 50% extra was a mistake by CYC, it seems to me that it should be returned to CYC rather than treated as income (but if it isn't returned, yes, the entire amount should be treated as income having nothing to do with an HSA).
2. If your Forms 5498-SA shows that only $6,166.52 of the $6,333.18 code W amount made it to the HSA, then the $166.66 should have been included in income on your 2016 tax return, but the statute of limitations for paying tax on the $166.66 expired about a month ago and you should be able to use the $166.66 as you see fit without any tax consequences.
I can't figure how they came up with $7 of interest ($166.66 + $83.33 + $7.01 = $257). $7 of interest seems way too much for a 0.5% annual interest rate over 3.5 years. With a 0.5% interest rate on $166.66 I get only $2.93 of interest. It would take a 1.2% interest rate to come up with $7 of interest on $166.66 over 3.5 years. Even if they calculated the interest on 1.5 * 166.66 it would take an interest rate of 0.8% to come up with $7 of interest over 3.5 years.
