By entering the current year HSA distribution to cover CUMULATIVE qualified expenses for PREVIOUS years, TurboTax does NOT include the distribution in the AGI. In addition, it is further subtracted from the California AGI.
If this is correct, one would accumulate his medical expenses every year until the cumulative amount exceeds 7.5% of AGI by a large amount before claiming a HSA distribution. This distribution would not be included in the AGI and would further reduce the California taxable income.
Let me illustrate with the following scenario. Could you please review if this is handled correctly?
From 2012 to 2017, the cumulative HSA contribution was $20000
From 2018 to 2020, the following medical expenses were incurred, but there was no HSA distribution.
Year, Qualified Medical Expenses, HSA Distribution, 7.5% of AGI , Effect on itemized deduction
2018, $6000, 0, $9000, 0
2019, $6000, 0, $9000, 0
2020, $6000, 0, $9000, 0
Cumulative qualified medical expenses was $20,000 from 2018 to 2020 and there was no HSA distribution during those years.
In 2021, a $20000 HSA distribution was used to reimburse the qualified medical expenses from 2018 to 2020. HSA distribution for qualified expenses was not taxable and not included in the AGI in both the federal and California returns.
Claiming itemized deductions for the medical expenses in TurboTax, one gets an extra $11K deduction in the California taxable income due to the $20K HSA distribution as shown in the data below extracted from TurboTax:
In Federal Schedule A (Itemized Deductions)
Schedule A has a caution at the top of the page saying "Do not include expenses reimbursed or paid by others." The medical expenses were reimbursed from HSA and therefore Line 1 is 0.
Line 1 Qualified Medical Expenses $0
Line 3 7.5% of AGI $9,000
Line 4 Line 1 minus Line 4 $0
In California Schedule CA (540) (California Adjustments — Residents)
Part II Adjustments to Federal Itemized Deductions
Medical Expenses
Line#, Column A, Column C
Line 4, $0, $11,000 $20000 (HSA distribution) minus $9000 (7.5% AGI)
Column C reduces the California taxable income.
The effect is that the $20K distribution is not included in the AGI. Yet the California taxable income is further reduced by $11K due to the HSA distribution to reimburse for CUMULATIVE expenses in PREVIOUS years.
If this is correct, a good tax reduction strategy for Californians is accumulate medical expenses every year until the cumulative amount exceeds 7.5% of AGI by a large amount before claiming a HSA distribution. This distribution would not be taxable and would further reduce the California taxable income.
