The moment that TurboTax (2023) detected an excess contribution from your employer contributions (code W), TurboTax adds your excess contribution ($3,874.86) to line 8f on Schedule 1 (1040). It does this because the code W amount ($7,749.86) was removed from Wages in boxes 1, 3, and 5 when your W-2 was printed. If you had not had the excess, then the entire code W would have been tax-free because it was not included in your income. So once it was determined that part of the code W amount was in excess and not eligible to contribute to your HSA, it was added back to Other Income.
Evidently, you were able to withdraw $2,128.66 before the due date of the 2023 return, and you got a 1099-SA ($1,746.20) with a distribution code of "2" and earnings in box 2. TurboTax applied a 6% penalty for your 2023 return on the $1,746.20 being carried over to 2024.
TurboTax is going to try to add the carryover amount to line 2 on form 8889 so that it can be used up as a personal contribution in 2024. If you limited your 2024 HSA contributions so that the $1,746.20 plus your 2024 contributions were less than or equal to your 2024 annual HSA contribution limit, the the carryover would be used up and gone.
But it often happens that taxpayers don't reduce spending in the next year, so the excess s just repeated.
Should I now include the $2,128.66 (excess contribution withdrawal) on Schedule 1, line 8z as Other Income with the note "Returned 2023 HSA contribution" so that tax will be charged on that and be done with it?
No. TurboTax has already taken care of things. The entire employer excess was taxed on your 2023 return, along with the 6% on the carryover. If you can use up all of the carryover in 2024, then the issue is done.
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