The distribution from the HSA was done improperly. After the due date of your 2019 tax return, including extensions, the excess must be corrected by an ordinary distribution made taxable by not applying it to any medical expenses and reported on a code-1 Form 1099-SA, not code-2. The HSA custodian should have recognized that because you made no contribution for 2020, there was no amount that was permissible in 2021 to be distributed as a return of excess contribution.
I would try contacting the HSA custodian to get them to issue a corrected Form 1099-SA showing code 1 instead of code 2 since they made an error by allowing this to be reported with code 2. Absent that, you'll need to enter it into TurboTax with code 1 instead of code 2, then print and mail your tax return so that you can include an explanation statement describing why the code 2 is incorrect.
When entering the code-1 2021 Form 1099-SA, you must indicate that none of this amount was used for medical expenses so that TurboTax treats is as taxable and correctly reports it on Form 8889 line 16 and on Form 5329 Part VII Line 44. If you were under age 65 at the time of this distribution, you'll also have a 20% penalty on Form 8889 Line 17b.
