Overfunded HSA in 2022 and took excess contributions out in March 2024 but still getting 6% penalty

[Marlee1]

In 2022 I overfunded my HSA by $149.  TurboTax applied 6% fee (form 5329) on that money and also added the $149 back into line 8 of 1040 Other Income.

In 2023 that same $149 was carried over and I again paid the 6% fee (form 5329).  I was advised by TurboTax advisor to withdraw the $149 from my HSA from 2022 as soon as possible to stop the 6% from happening again in 2024.  In March 2024 I withdrew $149 and was sent a 1099-SA form for that amount plus $1 for earnings.

I am now filing my 2024 taxes and after entering 1099-SA information the same 6% is being calculated and appears will also happen in 2025 and beyond.

How do I fix this once and for all?  Please note that I had an high deductible plan from Jan-July 2022 but did not have high deductible plan in 2023 or 2024.

Any help is appreciated.  Thanks!

[BillM223 · Accepted solution]

If you withdraw the amount equal to the carry over AND say that it was NOT for qualified medical expenses, then that will stop the carryover. It's not enough to just withdraw the money.

So go back into the HSA interview and tell TurboTax that this 1099-SA was not for medical expenses (even if it was).

This will have several effects:

1. The amount of the distribution in box of the 1099-SA will be added to Other Income.

2. You will be hit with a 20% excise tax (penalty) on that distribution.

3. The carryover will finally go away.

The calculation of the 20% penalty appears on the 8889, line 17b. Even if you can't see your output forms because you are using the Online product, you can see the 1040 and Schedules 1-3. Go to Tax Tools (on the left), then Tools (underneath), then in the center, click on View Tax Summary...then back on the left, click on Preview my 1040. Your 1040 and the three Schedules (if applicable) follow.

If you are looking to see if the 20% excise tax was imposed (meaning that your plan worked), it will be on Schedule 2, line 17c.

You should also note that the 5329 is no longer attached to your return (unless you have one of the many other conditions that use it).

One more thing. In the HSA interview, when TurboTax asks if you "overfunded" your HSA, just say NO.

[Opus 17]

"So go back into the HSA interview and tell TurboTax that this 1099-SA was not for medical expenses (even if it was)."

To be clear, only $149 needs to be "not for medical expenses."    If you withdrew more than $149, you should tell turbotax that it was not all used for medical expenses, and then when it asks how much was not for medical expenses, enter the $149 there .   The amount over $149 that you did use for medical expenses is still tax-free. 

[Opus 17]

Also note, if you withdraw the money "not for medical expenses" you pay income tax plus a 20% penalty.  That's a lot of tax.  It would take at least 5 years of 6% penalties to equal the tax on removing the excess as a withdrawal "not for medical expenses."

If you think you are likely to spend the account down to zero in the next 5 years (since you are not eligible to make new contributions, you are spending without replenishing), it may be cheaper in the long run to keep paying the 6%. 

[Marlee1]

@BillM223 

Thanks.  This makes sense but my 1099-sa has a distribution code of 2 in box 3 which says its an excess distribution.  Because of this I believe TurboTax never asks me if it was for qualified or non-qualified.  Should I change box 3 to normal distribution?  Can I do that without getting flagged?

[Opus 17]

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@Marlee1 wrote:

@BillM223 

Thanks.  This makes sense but my 1099-sa has a distribution code of 2 in box 3 which says its an excess distribution.  Because of this I believe TurboTax never asks me if it was for qualified or non-qualified.  Should I change box 3 to normal distribution?  Can I do that without getting flagged?

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Something is wrong here.

@dmertz 

Let's clarify the history. 

1. Why did you have excess contributions in 2022?  (Because your HDHP ended in July.)

2. Were you eligible in 2023?  (You said no.)

3. Did you in fact make contributions in 2023?  (Probably not, but confirm.)

4. Did you withdraw any money in 2024 for medical expenses, or only the $149 to correct the excess?

Here's the problem: The procedure to "remove excess" contributions for 2022 can only be made up through October 15, 2023.  Since the withdrawal occurred in 2024, it was not a removal of excess, it could only be a regular withdrawal. If you asked for removal of excess, the HSA bank should have told you no, and they should have known better than to use that code, even if you didn't know better.

I think you need to contact them and ask for a corrected form 1099-SA showing a regular withdrawal, then you can pay the tax and penalty and the excess will be cleared from the account.

I don't know what would happen if you changed the code on your return without getting a corrected 1099.  Turbotax would calculate the correct tax and penalty, but would anything happen at the IRS because of the mis-match?

[Marlee1]

@Opus 17 @BillM223 

1. Why did you have excess contributions in 2022?  (Because your HDHP ended in July.)

I believe that is why it was overfunded.  I had a new job in August and they didn't offer HDHP plan.

2. Were you eligible in 2023?  (You said no.)

New job did not offer HDHP plan (small non-profit)

3. Did you in fact make contributions in 2023?  (Probably not, but confirm.)

No

4. Did you withdraw any money in 2024 for medical expenses, or only the $149 to correct the excess?

Only the $149 for excess withdrawn.  I have $15k in that account and building it for retirement.

I am worried about the mismatch on the form but if audited it will show that I paid the 20% penalty so don't know if it would be a big deal or not

[dmertz]

The problem arises because the HSA custodian processed a return of a 2023 contribution before the due date of the 2023 tax return (code 2 on the 2024 Form 1099-SA).  However, there was apparently no new contribution made for 2023 that was itself an excess contribution, so the HSA custodian erred in processing the distribution this way.  As Opus 17 rightly points out, after October 15, 2023 the excess contribution made fore 2022 can only be corrected by either applying it as part of a future HSA contribution that you are eligible to make (after applying any new contributions made for that future year) or by obtaining an ordinary (code 1) distribution made taxable by not applying it to medical expenses.

[Opus 17]

@dmertz 

Would you suggest just changing the code to 1, or asking for a corrected 1099, and what if they refuse or don't understand?

[Marlee1]

@Opus 17 @dmertz 

I just spent an hour on the phone with BOA HSA and they said they cannot change the code from a 2 to a 1.  Very frustrating.  Do you think I should just change it myself and then if audited I can explain that they wouldn't correct it?  or how else should I handle?  

You both have been VERY helpful.  Thank you!

[BillM223]

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?

[dmertz]

Because there is no equivalent to Form 4852 to enter a substitute Form 1099-SA, I think it would be appropriate to enter a code-1 From 1099-SA and file with an explanation statement, but that can't be done by e-filing.  Alternatively, you could enter the code-1 Form 1099-SA and e-file without explanation, then if the IRS questions your tax return you could provide explanation at that time.

[Opus 17]

@Marlee1 

I agree, there isn't really a solution for e-filing.  If you were to file by mail, you would attach a written explanation, but Turbotax does not allow attachments when e-filing.  So using code 1, and then having an explanation ready in case you get a letter, is probably the better way to go. (Because e-filing is better than filing by mail for many other reasons.)

[Marlee1]

@Opus 17 @dmertz @BillM223 

Thank you all very much for the help! I really appreciate it.

I will change it to a 1 in order to pay the 20% penalty so that it finally goes away.  I will also prepare a letter for my files in case the IRS contacts me I will have it ready.

Thanks again for your help!