@Frozo40 wrote:
Wow, thanks for all the detailed response. This sounds unbelievable overwhelming and complicated. It’s a shame that the IRS has complicated something like this. I’m definitely at a loss at where to begin. It also sounds like a ton of money I do not have. The majority of the HSA has always been spent on my child’s medical care. Crazy.
As I understand it, here's what you need to do.
For 2020, stop making new contributions, and withdraw any remaining money as a "return of mistaken contributions". This will probably require you send the bank a a signed form of some kind. You want to end the year with zero balance. The penalty for all your past mistakes would be based on your account balance, so if it is zero, there is actually no penalty to pay.
Then going forward, if you ever become eligible to make HSA contributions again, you have a large penalty "accumulated" from the past. You can avoid paying this if, for every year that you contribute to your HSA, you spend it all down to zero at the end of the year. You would get the benefit of paying expenses tax-free but you lose the benefit of accumulating the excess in your account long-term, which can really add up (it becomes effectively like a "super IRA" if you can fully fund the account and don't have to spend it.)
Depending on your age and other situations, you might want to clear that penalty so that you can accumulate savings in the HSA for your long term future. Here I see two possibilities.
1. Pay the penalty off. According to Dmertz, this is done by withdrawing the excess at the end of every year and paying income tax and a penalty on it until you have used up the penalty balance. Then you could accumulate future funds tax and penalty-free.
2. You might be able to sit tight until the statute of limitations expires, this is 3 or 6 years, depending on the size of the error. If you sit on your hands until the statute of limitation expires (April 15, 2023 or 2026 for a 2019 return) then maybe you can pretend the mistake never happened and contribute to a new HSA at that time without fear.
I would not undertake either of these two steps without competent professional advice. But, suppose you are 35 years old, your single HSA contribution limit is $3500 (plus inflation adjustments) and your medical expenses are $2000 per year. If you cleared the penalty so that you could allow your HSA funds to accumulate, and if you invested them in a conservative mutual fund instead of whatever pitiful interest rate the cash account pays, you could have over $100,000 by age 65, that you could withdraw tax-free for medical expenses or withdraw and pay income tax like an IRA but with no penalty. It may be to your long term advantage to have a professional figure out the best way to clear the penalty so you can use the substantial benefits of an HSA going forward.
