Deductions & credits

@MrHarriet 

I forgot about the special rule for withdrawing HSA funds after the tax deadline (as long as you file an on-time return) and reporting it on an amended return with the special instructions. Because of the requirement to add a written statement, you won’t be able to e-file your amended return.  Don’t make a regular withdrawal from the HSA, request a “return of excess contribution.“  If you earned any interest or dividends on the excess contributions, they must also be returned to you, and that will be reported as taxable income on your 2023 tax return.

 

You must still amend your 2021 return to pay the penalty on the excess contribution for 2021, and because that excess contribution is still in your account at the end of 2022, you will pay another 6% penalty on that amount on your amended 2022 return, even though you will remove the 2022 excess contribution.

 

As I mentioned before, you have several options on how to remove the 2021 excess contribution.  You can withdraw it as a non-qualified withdrawal and pay regular income tax plus a 20% penalty.  Based on your scenario, I believe the excess would be $600, so the tax and penalty will be somewhere around $250.  Or, you can leave the excess in the account and pay the 6% penalty year over year until you become eligible to make contributions again, in which case you can use up the excess by counting it toward your new contribution limit. 

HSA accounts don’t follow FIFO rules, if you have $600 of excess in the account today, and you don’t perform the procedure to remove it or use it up, it will be penalized as long as you have any funds in the account.  However, this doesn’t remain with you forever. If you were to spend the account balance down to zero in the next couple of years (because you have a new baby and you choose to spend the account on out-of-pocket medical expenses) then once your account has a zero balance, the excess is considered removed. The excess does not reappear once you become eligible to make new contributions again.  You “get straight” with the IRS by either withdrawing the excess contribution as a taxable, non-qualified distribution, or by spending your account to zero on non-taxable qualified medical expenses, or by applying the excess to your new contribution limit if in the future you become eligible again.  

It seems a shame to spend $250 this year on taxes and penalties with a lump sum non-qualified withdrawal, when you would only have to pay $36 a year in penalties if you left the money in the account. I guess it depends on what medical expenses you think you will have and how your insurance coverage might change over the next 5 years.