Deductions & credits

OK thanks. This situation is quite simple, unfortunately you will pay end up paying a substantial amount of penalties.  If you have the money well invested, you might have earned more than the amount of penalty even so over the recent few years.

For 2018, you have as you say, $3450 of excess contributions. Because you cannot remove those contributions before April 15, 2019, the tax consequence is that the $3450 is not tax deductible, it is added back to your taxable income, and there is an additional 6% penalty.  This will be calculated on a form 5329, which TurboTax or your tax preparer will prepare as part of your 2018 tax return.

At this point, the only way to fix the excess contribution issue is to use up the excess amount by contributing less in the current year and treating the excess as a current year contribution. You can stop thinking about removing the excess and it’s earnings, that procedure is no longer relevant.  I will explain how that might work.

On your 2019 tax return, you must report that you had a $3450 excess from 2018. This will require that you have a copy of your 2018 form 5329 on hand when you prepare your 2019 tax return.  The 2019 contribution limit for a self only plan was $3500. Let’s assume that you only contributed $2500. You can consider that $1000 of the excess counts as a 2019 contribution, making your total 2019 contribution $3500 and the remaining excess is now $2450. You will pay a 6% penalty on the remaining excess on your 2019 tax return. However, if you already maxed out 2019 by contributing the full amount, then you still have the full amount of excess in your account and you will pay the 6% penalty on $3450. This will be part of your 2019 tax return on form 5329.

You will do the same calculation when preparing your 2020 tax return and you will need to have your 2019 form 5329 on hand.  Any amount of excess contribution that you can’t use up in 2020 will be subject to the same 6% penalty.

Finally, we reach 2021.  The maximum self only contribution for 2021 is $3600. Let’s assume in the worst case scenario, that you maxed out your 2019 and 2020 contributions, which means that you will pay the 6% penalty on the full $3450 in each year 2018, 2019, and 2020.  Now 2021 is when you can eliminate that penalty for good. You must contribute $150 (or less) of new funds into the HSA for 2021. That will allow you to treat the excess that you have been carrying forward as your 2021 contribution.  That will use up the excess and it will no longer be an issue going forward.  If you have already contributed more than $150 for 2021, you need to contact the HSA bank and request a “return of excess contributions“.  Make sure you tell them that you are requesting a return of the 2021 contributions that you have already made. Don’t tell them it is a return of 2018 contributions, because it’s not. It’s a return of 2021 contributions, so that you can get your 2021 contributions low enough that you can use up the excess carryover.  The bank will also be required to return to you any earnings from the 2021 excess that they are sending you, and that will be reported as taxable income on your 2021 tax return. 

because the penalty is based on the amount of excess, or the amount of money in the account, which ever is smaller, it would also be possible to eliminate the excess as a future concern if you spent the account down to zero. However, if you don’t have a large medical expense, then the withdrawal would be subject to a 20% penalty, on top of the penalties you have already paid, so I don’t think this is the way to go at this point.

Because it is after May 17, 2021, you can’t make retroactive adjustments for 2020.  But as 2021 is ongoing, it should be relatively simple to make sure that your $3600 of contributions for 2021 only include $150 of new money plus $3450 from the excess.

Of course, if you made smaller than maximum contributions in 2019 or 2020, then you will have used up some of the excess already, and that will allow you to put more new money into the account for 2021, as long as the new money for 2021 plus the excess that you are trying to eliminate, totals no more than $3600.  

And of course, this plan that I have outlined assumes that you are still covered by a self only HDHP, and that you have maintained eligible coverage throughout the years we are talking about.