Should the additional income from a Qualified HSA funding distribution that did not meet the testing period requirement be reported as 2016 or 2017 income?

[joe24]

I made  a qualified HSA funding distribution from an IRA in March 2016.I became ineligible on March 1 2017, When I read the IRS Pub 969 it says the now taxable income from that distribution is reported in the year you become ineligible.  In my case March 2017.  TurboTax is reporting this as 2016 income    Am I misunderstanding the IRS instructions?  If not, how do I work around this?

[dmertz]

It's unfortunate that you missed completing the HFD testing period by less than a month.  Failing to meet the testing period does not make it an excess contribution, but it does make the HFD taxable and subject to a 10% penalty on your 2017 tax return.

TurboTax doesn't have a separate question for failing to meet the testing period for an HFD.  However, this is treated the same way as failing to satisfy the testing period for the last-month rule.  In 2017 TurboTax you'll indicate that you made a contribution under the last-month rule and that your entire HFD amount was Excess Contribution Amount Using the Last-Month Rule.  ("Excess contribution" here is a misnomer, even in the case of actually using the last-month rule.)

You might consider reporting this as a regular taxable distribution from your IRA, subject to the 10% early-distribution penalty, and a regular deductible HSA contribution under the last-month rule.  This would allow you to pay tax and an additional 10% penalty only on the portion of the contribution for the first 3 months of 2016 that you were not eligible for an HSA contribution.  Paying 10% penalty on the entire distribution from the IRA plus tax and 10% penalty on only the additional HSA contribution made under the last-month rule could be less than paying tax and penalty on the entire amount of the HFD.

[joe24]

Thanks for replying dmertz
I thought the income is reportable in 2017 too.  The problem is in TurboTax, there is a question asking if you meet all the requirements for the qualified HSA funding distribution.  It's in the Federal>Deductions>Medical>1099-SA, HSA...section.  Once I answer no, the program automatically adds the 10% penalty to the 2016 tax due, and the distribution amount to the 2016 income.  How do I undo this?  Should I answer yes, I meet all the requirements, then manually edit the 8889 form?  Will everything else update correctly if I do this?  
I can't use your suggestions for alternate reporting since the 1099-R has already been prepared by teh custodian and sent to the IRS.  Also there is no last month rule for this type of distribution as far as the IRS is concerned.  The testing period begins with the month you make the distribution.

[dmertz]

I would answer "Yes, I will meet these conditions" and leave it at that.  There is nothing to manually edit on the Form 8889.  The instructions in IRS Pub 969 are derived from IRS Notice 2008-51 which includes, "The qualified HSA funding distribution is included in gross income in the taxable year of the individual in which the individual first fails to be an eligible individual.  This amount is subject to the 10 percent additional tax (unless the failure is due to disability, as defined in § 72(m)(7), or death)."  This part of Notice 2008-51 derives from section 408(d)(9)(D) of the tax code:  <a rel="nofollow" target="_blank" href="https://www.law.cornell.edu/uscode/text/26/408#d_9_D">https://www.law.cornell.edu/uscode/text/26/408...>

TurboTax's is simply asking wrong question.  Instead of asking if you will remain an eligible individual throughout the testing period, TurboTax *should* be asking if you remained an eligible individual through the end of 2016.  If not, you include the income and pay the penalty with your 2016 tax return.  If you remained an eligible individual throughout 2016 but failed to remain an eligible individual throughout the remainder of the testing period in 2017, as in your case, the income and penalty are to be reported on your 2017 tax return.

Regarding reporting this as a regular distribution, a Form 1099-R includes no indication that the distribution was an HFD.  An HFD is reported on Form 1099-R the same as any regular distribution from your IRA.  The only thing that makes the direct transfer to the HSA an HFD is the reporting of an HFD on your tax return.  Nothing prevents you from treating it as a regular, non-HFD distribution and separate HSA contribution instead.

[joe24]

OK, got it.  Thanks again.