Excess HSA Contribution Withdrawal After Changing States

[xLnsi1jbpL]

Hi,

My HSA was overfunded last year by the job I held for the first half of the year. At the end of this job, I moved to a different state and changed residency. I didn't realize I needed to correct the funding amount until tax time this year after I had moved to a new state. I requested a distribution of the excess contribution from my HSA. My question is what state should the excess contribution be taxed in? The income was earned in my previous state (largely - I worked very briefly for my old employer in my new state) and, had the HSA not been overfunded, would have been taxed there. However, the distribution was not requested and made until I lived in my new state. Since this might be state specific, I moved from California to Arizona.

Thank you for your help!

[BillM223]

What is the most relevant thing here is that California does not recognize the deductibility of HSA contributions. For California, an HSA is just another investment account and you have to pay tax on the earnings from the account.

Since nearly all the HSA activity was in California, let's talk as if it were 100% California. This gives rise to the following:

1. As soon as TurboTax sees that you made excess HSA contributions, the excess is added back to Other Income on the federal return. The timing is not dependent on when you ask for the distribution.

2. Since HSA contributions are not deductible in California and since all of the contributions were made in California (for purposes of this discussion), all of the contributions made through your employer (i.e. as shown with code W in box 12 of your W-2) are added back automatically to CA state income by TurboTax - you don't have to do anything.

3. As noted, you need to report the earnings of the HSA account as if it were an investment account - this will probably require a special call to your HSA custodian.

If your time in Arizona working for this company was less than 2 weeks, both the CA and AZ returns might be correct "as is" out of TurboTax. If you spent more weeks working in AZ for this CA company, come back and let us know how long it was (in terms of weeks or days), and we'll see if it will make much of a difference and how to enter it.

[xLnsi1jbpL]

Thanks for the response! I see that TurboTax has automatically added the HSA to my California income, which makes sense. However, TurboTax has also removed the excess contributions (I have successfully withdrawn them, but again, this happened in Arizona) from California, so the only amount included now in the HSA is the non-withdrawn portion. I believe it copied this from the federal return.

I understand that California taxes that (and interest - which I've handled separately), but it's not clear to me whether that amount (the excess amount only) should be deducted from California. It seems as though TurboTax removes that withdrawn amount from the California HSA adjustment and expects me to apply it as part of my AGI. Normally (ie in a one state case), it seems like the AGI from the federal return (which already includes the HSA excess contribution funds returned to me) would take care of carrying it over to California (other adjustments - such as the non refunded portion of the HSA - would happen after). (Also, please correct me if I'm wrong here - TurboTax automatically removed the refund from my California HSA contribution line and included it in AGI. Please do let me know if this is expected behavior!) In my case, though, I'm asked to split up the AGI between two states. My question is whether that excess contribution refund portion of the AGI should be counted as California income or Arizona income.

Or is it the case that the only part that matters as far as California is concerned is what I originally funded with (ie the refund makes no difference to California)?

And then that raises another question - is it possible that this is taxed by both states?

[xLnsi1jbpL]

merged into post above

[BillM223]

The way this works is this:

1. If the HSA contributions are made through your employer, they appear in box 12 of your W-2 with a code of W. This amount is removed from Wages in boxes 1,3, and 5 before your W-2 is printed. 

2. Therefore, since federal income does not include the HSA contributions made through the employer, these contributions must be added back to CA state income (which is derived from federal adjusted gross income).

3. On the federal return, the excess HSA contributions are added to Other Income, because these contributions that turned out to be excess were removed from Wages before the W-2 was printed. 

4. As for as CA is concerned, there is no such thing as an excess HSA contribution, so the excess HSA contributions found in the federal Other Income has to be removed from CA state income.

5. Simply put, whatever was done on the federal return vis-à-vis the HSA needs to be undone in CA. TurboTax does this automatically, on the assumption that your return is 100% CA. This include any penalties paid if you had rolled over the excess contributions, and any penalties for taking a distribution for non-medical expenses.

6. You use the word "refund" - do you mean the amount of excess contributions withdrawn from the HSA? CA does not care if you withdrew the excess or not, CA only cares if the excess was added to Other Income. If this is puzzling, just think of an ordinary investment account on your federal return. What would CA think of you making contributions to that account (hint: nothing)? What would CA think about you withdrawing amounts from the account (again: nothing)?

As for double taxation, most states make some effort to avoid it in a variety of ways. HSA things in Arizona are taxed just as they are (or aren't) on the federal return, while CA undoes everything the federal return does. I don't see anywhere where the question of double taxation would apply.

Does that cover everything?

[xLnsi1jbpL]

Thanks! Yes, by refund I'm referring to the withdrawn money to correct the excess contribution - sorry for the confusion. This answers it for the most part, although to respond to your confusion about double taxation -

Right now I have that California taxes the original HSA contribution (which includes both the "true" HSA contribution and the excess contribution - California does not distinguish between these two) and the federal government taxes only the excess contribution. This still leaves the question of Arizona in the air since the money was withdrawn while I was an Arizona resident. Would Arizona also tax the withdrawn money as income? (The federal government does, but I was subject to federal government taxes this entire year, so anything I incurred while in California would also be counted on the federal return. The key difference is that I wasn't subject to Arizona taxes this entire year.) If this withdrawal is considered part of the income I incurred while an Arizona resident (and thus subject to Arizona tax), the withdrawn money is taxed by both California and Arizona. For California, it would have been included in the original taxable HSA contribution and for Arizona it would be taxed when I report the excess contribution withdrawal as income. The question is mainly whether this needs to be reported as excess contribution withdrawal to Arizona (I think the California question is clear at this point - it was already taxed in California when I added it to my HSA). Since the withdrawal happened while I was an Arizona resident, it seems like the answer is yes, but I'm confused because fixing the excess withdrawal as fixing an issue that was made with my California income while I was a California resident.

[BillM223]

"This still leaves the question of Arizona in the air since the money was withdrawn while I was an Arizona resident. " - As I noted above, it does not matter when the excess HSA contributions are withdrawn. The excess is added to your federal Other Income the moment that the excess is detected by TurboTax.

"Would Arizona also tax the withdrawn money as income? " - Yes, because the excess contributions are added to federal Other Income, which flows to Arizona state income.

"the withdrawn money is taxed by both California and Arizona." -- to repeat, the excess contributions (whether are not they were withdrawn is completely irrelevant) are NOT taxed by California. As noted above, California starts with federal adjusted gross income, then adds and subtracts HSA items to undo what was done on the federal return. This includes adding excess contributions to Other Income.

"Since the withdrawal happened while I was an Arizona resident" - please stop dwelling on when the excess amount was withdrawn - it is irrelevant. If the excess amount is never withdrawn, it is still added to Other Income on the federal return as soon as TurboTax detects the excess contribution. And it is still ignored in California because it is not possible to have an excess contribution to an HSA in CA, because HSAs are not special accounts in CA. The excess amount will be taxed in Arizona no matter what because this flows from the federal return to Arizona no matter what happens in CA.