To fix an excess HSA contribution, you must notify the HSA custodian that you want to "withdraw" an excess contribution. The custodian will have you complete a form, and they will send you a check for the amount.
You cannot fix an excess contribution by distributing the amount, except in the following case.
You must "withdraw" an excess contribution by April 15th (or whatever the due date is) to avoid any excise tax. If you miss that date, then a "distribution" will not fix the problem unless you make a distribution NOT for qualified medical expenses. In this case, the distribution will be added to your taxable income AND you will be penalized an additional 20%.
This is because the "excess" has nothing to do with how much you have in the HSA, but with how much you contributed in a given year.
In rereading your post, I have to say that if you have not gone on Medicare, then this excise tax will continue year after year until you make distributions for non-qualified medical expenses, in order to wipe out the excess. Reducing the HSA balance to zero WILL zero out the penalty, but if you ever go back on an HDHP plan, then the excess contribution that has been carried over will just start the excise tax up again. Reducing your HSA balance to zero only sets the current year penalty to zero - it does not "fix" the carryover, which will just keep carrying over.
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