Deductions & credits

California treats Health Savings Accounts as ordinary investment accounts. This has multiple consequences.

• Contributions to an HSA are not deductible on the CA state return.
• If the HSA contributions were "employer contribution" (code W in box 12 of your W-2), then this amount is added back to CA state income.
• If your HSA contributions were "personal" (i.e., directly to the HSA, not through your employer), this is also not deductible, but listed on a different place on the CA return.
• The add-backs for contributions to the HSA are normally handled automatically.
• Earnings in the HSA are reported as income on the CA return.
• The reporting of the HSA earnings you have to do manually.

The mutual funds in the HSA are taxable to the same extent as they would be on the federal return outside of an HSA. Mutual funds typically generate taxable income even if you don't buy or sell any shares in the fund, because of interest and dividends and because of stock transactions by the fund's managers.

So, it's a pain, but you need to contact the HSA custodian and find someone who understands that you have to report the earnings from the HSA (only CA and NJ require this).  (***NOTE** the answer above predates this year, because now there are only two states like this).

Just to be clear, this applies only to your state return. Your federal return treats the HSA as you think it does - earnings are not reported because they are deferred.