Marlee1
I am not surprised that the HSA custodian declined to make the change in the distribution code - my experience has been that they won't make changes for a previous year, even when they were obviously in the wrong.
I want to thank Opus and dmertz for bringing out more facts - I did not realize that the distribution code on that 1099-SA was 2 instead of 1. Yes, Marlee, since the code was 2, you were not asked about the qualified versus not medical expenses.
So it's clear that the HSA custodian didn't know what they were doing and made a big mistake, and now they won't fix it. What can you do?
Well, I normally do not advise taxpayers to change forms that they received, because the IRS gets a copy of these forms, and if they notice a difference, you can expect a letter asking why, and sometime proposing adjustments to your return using some real imagination.
However, in this case, because of the HSA custodian's error, I think that changing the distribution code on your 1099-SA from 2 to 1 (which is what it should have been), then indicating that the first $149 (as Opus points out) was not for qualified medical expenses, thus causing the three steps I indicated above: added the Other Income, 10% penalty, and terminating the carryover.
So change the distribution code to 1, document everything you have seen here, and save it in your tax archive, in case any one ever asks. @dmertz, @opus, what do you guys think?
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