Get your taxes done using TurboTax

Jerry, I fouled up a little. When TurboTax detects excess contributions AND when these contributions are "employer contributions" (i.e., part of code W in box 12 on your W-2), then TurboTax immediately adds the excess to Other Income (line 8 on Schedule 1 (1040), whether or not you actually withdraw it from your HSA or carry over to the next year. I apologize for saying differently.

The form from your HSA custodian is misleading. It asks you "How would you like the funds distributed?" But when you have a carryover to the next year, the IRS does not refer to it as a "distribution". This is what confused me, because you can't actually withdraw excess contributions (which IS a distribution) and have a carry over at the same time (which is NOT a distribution in the land of the IRS). You can see this because a withdrawal will generate a 1099-SA to be sent to you, whereas the carry over will not generate a 1099-SA.

So the custodian's form is misleading in its terminology. Please ignore its use of the words.

You chose Option 1, which was to carry the excess over to next year. So the 3,550 was added to Other Income (good) and you did not get an actual distribution (a check) from the custodian. When I say "cure" the excess, what I mean is that when you ask for a withdrawal of the excess (and the custodian sends the excess to you which is Options #2 and #3), then the excess is "cured", that is, it is as if the excess never happened. So you no longer talk about having an excess in 2020, and when TurboTax asks you in 2021 if you "overfunded" your HSA in 2020, you would answer "NO" because the excess never happened.

However, in your case, as you know, you carried over the excess to 2021. The carryover should be done automatically by TurboTax (assuming you used TurboTax the previous year). You might not even see this question about overfunding because TurboTax should see the carryover on the Carryover Worksheet - note that if you are an Online user, I don't know if you can see the Carryover worksheet even of you pay for the return and can see all the other forms (you might look) - I see it in the forms list of the CD/download software. 

"For the 2021 tax, your are right, my contribution limit is 7200-3550 = 3650, and I contribued 10540, which is 6890 excess contribution. Since I have withdraw 3000+2610 on Mar 2021, I just need to withdraw another 1250 = 6890-3000-2610 before 4/15/2022, and in turbotax, I should choose "(1) you would withdraw it", and I am good to go, right?"

Well, no. This is one of the most difficult things to understand. The excess for 2020 is separate from the excess for 2021. Remember I said that you have to withdraw the excess by the due date of the return? The due date of the 2020 return was either May 17, 2021 or June 15, 2021 (see the discussion in the previous answer), so we are passed that; you can no longer withdraw that 3,550. This is difficult for taxpayers to understand because both the 2020 excess and the 2021 excess are called "excess" but they are not treated in the same way.

So your withdrawal of 5,610 plus 1,250 doesn't do what you think it did. You were allowed under the rules to withdraw only the 2021 excess of 3,340 (6,890-3,550); the only way to clear the 3,350 from 2020 is to report it as a distribution not for qualified medical expenses.

But I don't think that TurboTax will let you try to withdraw the entire 6,890. It should give you another screen saying that you can withdraw only the 3,340 , and that you have to treat the 3,350 from 2020 differently. But you may not have gone far enough through the interview to see it.

Go a little bit farther in the HSA interview and see if this screen pops up.

In any case, you can certainly withdraw another 1,250. However, on the 1099-SAs that you get for the two distributions (the 5,610 and the 1,250) you have to indicate that a total of 3,350 is not for qualified medical expenses. You will do this on your 2022 return when you can enter these 1099-SAs. Marking the 3,350 as not for qualified medical expenses would make the amount taxable and you would also get a 20% penalty.

BUT, as I have explained, you have another option. Since TurboTax won't let you withdraw the 3,550 (in terms of your tax return), it will rollover to next year - so in 2022 CUT YOUR HSA CONTRIBUTIONS so that the 3,550 will be used up in 2022. If you use TurboTax next year, this will be done automatically, and you will finally be done with it.

So to make this work, don't withdraw the 1,250 AND report to the HSA custodian that you asked for a mistaken distribution of 2,270 when you made that withdrawal in March 2021 of 5,610. That is, you were legally able to withdraw 3,340 (the excess for 2021) of the 6,890 excess and just needs to carry over.

If you can do this the way I have outlined in the previous paragraph, you will save the 20% penalty at least. 

I know this is very confusing but in this way your tax returns will match the records of the HSA custodian if you are ever audited.