Current Year HSA Distribution for Medical Expenses for Past Several Years Together for California Return

[ThoYoung]

I opened a HSA account in 2015. From 2016 to 2019, I had yearly SMALL medical expenses that I DID NOT use HSA distributions. I also DID NOT itemize these expenses and claim deductions in the Federal returns in those years. But cumulatively these added to a sizeable amount.

Finally in 2021, I used a HSA distribution of $20,000 to cover theses medical expenses incurred from 2016 to 2019. I entered this HSA distribution in TurboTax and answered that this was used completely to cover qualified medical expenses. The Federal return handles this correctly by including Form 8889 showing that this distribution was not taxable.

However, the California return considers this distribution as covering 2021 qualified medical expenses and enters the HSA amount greater than 7.5% of AGI in Form CA (540) Line 4c as an addition to the deduction. These were actually 2016 to 2019 qualified medical expenses and should not be claimed as a deduction for 2021.

How do I enter the 2021 HSA distribution covering qualified medical expenses from 2016 to 2019 in order for TurboTax to generate both the Federal return and the California return correctly?

[BillM223]

You have entered it correctly.

California uses the same floor as the federal return for medical expenses - medical expenses in excess of 7.5% of your AGI can be deducted.

And as you know an HSA is treated like an ordinary investment account in California. So why it seems to you that you should not be able to deduct HSA distributions because they were tax-advantaged on the federal return, these same distributions were NOT tax advantaged on your previous California returns.

And since the HSA distributions were only for qualified medical expenses, then, yes, they should be added to medical expenses in California.

The timing does present an issue, because you are permitted to pay for medical expenses that happened perhaps years before with your HSA (so long as the expense was incurred after your HSA was created). Because of this, you end up "paying" a medical bill perhaps a year or two or three after you actually did. Yes, you probably paid those bills at the time, and what happened last year was that you reimbursed yourself - but TurboTax has no way of knowing what bills you paid when.

I have not seen any IRS documentation on how to handle this, so I suggest that you let TurboTax do what it is doing. Just keep good notes about what happened in case anyone ever asks (unlikely).

[ThoYoung]

By entering the current year HSA distribution to cover CUMULATIVE qualified expenses for PREVIOUS years, TurboTax does NOT include the distribution in the AGI. In addition, it is further subtracted from the California AGI.

If this is correct, one would accumulate his medical expenses every year until the cumulative amount exceeds 7.5% of AGI by a large amount before claiming a HSA distribution. This distribution would not be included in the AGI and would further reduce the California taxable income.

Let me illustrate with the following scenario. Could you please review if this is handled correctly?

From 2012 to 2017, the cumulative HSA contribution was $20000

From 2018 to 2020, the following medical expenses were incurred, but there was no HSA distribution.

Year, Qualified Medical Expenses, HSA Distribution, 7.5% of AGI , Effect on itemized deduction
2018, $6000,                                       0,                              $9000,            0
2019, $6000,                                       0,                              $9000,            0

2020,  $6000,                                       0,                              $9000,            0

Cumulative qualified medical expenses was $20,000 from 2018 to 2020 and there was no HSA distribution during those years.

In 2021, a $20000 HSA distribution was used to reimburse the qualified medical expenses from 2018 to 2020. HSA distribution for qualified expenses was not taxable and not included in the AGI in both the federal and California returns.

Claiming itemized deductions for the medical expenses in TurboTax, one gets an extra $11K deduction in the California taxable income due to the $20K HSA distribution as shown in the data below extracted from TurboTax:

In Federal Schedule A (Itemized Deductions)
Schedule A has a caution at the top of the page saying "Do not include expenses reimbursed or paid by others." The medical expenses were reimbursed from HSA and therefore Line 1 is 0.

Line 1 Qualified Medical Expenses $0
Line 3 7.5% of AGI $9,000
Line 4 Line 1 minus Line 4 $0

In California Schedule CA (540) (California Adjustments — Residents)
Part II Adjustments to Federal Itemized Deductions
Medical Expenses

Line#, Column A, Column C
Line 4, $0,              $11,000              $20000 (HSA distribution) minus $9000 (7.5% AGI)

Column C reduces the California taxable income.

The effect is that the $20K distribution is not included in the AGI. Yet the California taxable income is further reduced by $11K due to the HSA distribution to reimburse for CUMULATIVE expenses in PREVIOUS years.

If this is correct, a good tax reduction strategy for Californians is accumulate medical expenses every year until the cumulative amount exceeds 7.5% of AGI by a large amount before claiming a HSA distribution. This distribution would not be taxable and would further reduce the California taxable income.

[BillM223]

I have reflected on this for several days, as I am concerned that such devices would just appear to be a way to avoid taxes in California (which it is, of course). But then I see this in the CA instructions: "Health Savings Account (HSA) Distributions – If you received a tax-free HSA distribution for qualified medical expenses, enter the qualified expenses paid that exceed 7.5% of federal AGI on line 4, column C."

Clearly, the rules for an HSA allow for you to reimburse yourself for medical expenses from years before, so either the author of these instructions does not know this or does not care.

If you take this course, I would suggest that you document why you are taking a large HSA distribution to pay for prior year medical expenses, for example, to minimize service fees by the HSA custodian or because you have had a lot of expenses pile up.

Alternatively, there may be a court case on this subject, but I don't have the means to research this.

You might try sending this question to the CA Franchise Tax Board, I would do it by email, if possible, because no one is going to have the answer off the top of their head.

Good luck!

[usapayer]

[surprise answer at end] I did nothing special on my TurboTax this time. I did have more legit unreimbursed medical expenses than usual, but not enough to get any federal relief. I also coincidentally cashed out my HSA in 2022 when I finally accumulated enough multiyear expenses to justify asking for a reimbursement (my reason for waiting was saving the fees to the HSA holder by keeping the balance over a threshold). I see that even though my CA Part II line 1 is slightly less than line 3, and line 4, column A is thus zero, TurboTax has entered a mystery amount into line 4, column C. Wondering where that came from, I tried adding on paper line 1 to my reported HSA distribution and then subtracting line 3 from this larger amount, and voila!: exactly that amount is on line 4, column C.
So it appears that TurboTax has already given me the credit that is being discussed here without me trying to game the system. So perhaps nothing to do here, folks?

[CarltonH]

I am looking to amend my 2021 California return for the same reason.  I didn't include medical expenses for federal return as it was under the 7.5% AGI limit, but that was due to a larger HSA distribution.  When I add that distribution back in for California it amends my CA return with a positive amount.  

I too don't see any change to the value on Line 1, in fact the math doesn't work, but the amount on line 4 looks correct, so there appears to be an error in this case in Turbotax as it fills that portion of the form, but the outcome is correct.

Since I am doing an amended form, I guess I will do it by hand to get it to look correct and then mail it in.