The best you can do is the right thing for your tax return, and let the chips fall where they may with your HSA custodian and your husband's employer.
So was the code W amount in box 12 of his W-2 correct? Or did it include the $500 plus $40?
If you enter just the code W amount, do you get the HSA excess contribution error message?
The $500 was withdrawn by the employer. Never minding that the employer may have done that wrong (although there is a circumstances in which the employer can do it), is it part of the code W amount?
As for what happens to the $540 sent back to the employer, no, you should (1) not report it as income (it's not in Wages on his W-2, is it?), and (2) you should not report the distribution, either. So no penalty on the distribution that you didn't even ask for. If the HSA custodian sends you a 1099-SA with a distribution code of "1" for the $540, just cross it out and stick it in your tax file (not tax return).
Don't worry about the 5498-SA - it can only be understood during a multi-year audit. Don't worry about the 8889 - if line 2 is blank (your direct HSA contributions, which I don't think you had any of) and line 9 is the code W amount - then that part of the 8889 is OK.
And if I right so far, you won't see an excess HSA contribution message, so there is no penalty here, either.
So, let me know - can you just enter what the code W amount is in the W-2, and get no error message?
If so, be sure to write down everything that has happened (especially the bad advice from the employer and the HSA custodian), and be satisfied that you did the best you could.
**Say "Thanks" by clicking the thumb icon in a post
**Mark the post that answers your question by clicking on "Mark as Best Answer"
