How do I correct 2017 HSA contributions which will violate the "2017 coverage"/"2018 testing period" rules with the minimum penalty/tax total?

[A-better-name-is-required]

I will have HDHP coverage from October 1st 2017 through May 31st 2018.  I will have HMO/PPO coverage for all other months in both years.  I have contributed over the $850 prorated maximum (if you fail the testing period) for 2017 (but not over $3400), and have not yet filed my 2017 taxes.

According to IRS publication 969, if I leave it as is, I will be subject to taxation on the excess amount exceeding my $850 prorated limit at my 2018 marginal rate + 10% penalty (on form 5498-T, I believe).  However, if I withdraw the not-excess-but-will-be-excess before my filing date (and receive/file/pay tax on the 1099-SA code 2), I will be subject to a 20% unqualified distribution penalty for 2017 taxes, and the withdrawal might even technically be considered fraudulent, even though it would be made in good faith, attempting to comply with the rules.

How can I correct this and dodge the penalties?  The contributions are already made, I'm just trying to undo them back to what the rules will be...once I fail the last month rule testing period in 2018, which I have not yet done, but WILL definitely do.

My 2018 contributions are within my 2018 prorated per month limits, so I don't need to worry about that again next tax season, thank goodness.

[Opus 17 · Accepted solution]

You aren't subject to a withdrawal penalty if you request a "return of excess contribution" from the HSA bank.  They return the excess to you (along with the earnings from the excess).  The contribution and interest are added back to your taxable income.

This requires a special procedure or form, not a normal withdrawal.  Make sure you contact the bank and ask them how to do this.  And it must be done before April 17, 2018.  When Turbotax tells you that you made an excess deposit, there should be a box to check for "I will remove the excess contribution before April 17."

[A-better-name-is-required]

Within TurboTax, there is not a mechanism to allow for knowing (or to alert you about!) that you will face or violate the last month rule's testing period.  It considers my maximum as $3400 for 2017, and flags my withdrawal since it's below the $3400 limit, as I'm sure the IRS would as well.  I already have the bank paperwork prepared, I'm just not sure how to handle the filing detail to avoid penalties.  Might it be accepted without penalty if accompanied with a simple explanation note on 8889 for parts 2 and 3?, explaining my foreknowledge of failing the testing period?

[Opus 17]

@dmertz can you help here?

[A-better-name-is-required]

Unfortunately he has already been trying to 🙂  I really appreciate the help from both of you though, it's not a simple answer, though the situation is quite simple!

[Opus 17]

I believe in this case, you simply report you made $850 in contributions.

[Opus 17]

I'm sure he is right then, he's basically the best expert we have on this.  If you are not permitted to make a withdrawal of excess contributions because you met the last month rule at the time, then you aren't permitted, and you are stuck with the 10% tax in 2018.  It's not excess for 2017 when considering your 2017 situation as of 12/31/17.

I wonder about stopping your 2018 contributions though.  As it is, you are on track to contribute $3400 in 2017 and $1437.50 in 2018.  That adds up to a $2550 excess at the end of 2018 due to the testing period.  If you stopped your 2018 contributions immediately, you might end up only contributing $862.50 in 2018.  That would mean that, overall, your excess is only $1975, and might reduce your penalty.  (Some of the 2017 excess is absorbed by the allowable amount for 2018.)

That works for ordinary excess contributions although I'm not sure it works in this case.

[A-better-name-is-required]

That's an excellent point.  I already stopped my 2018 contributions as soon as I realized there was a problem, and am right above my limit for April due to employer contributions.  The excess absorption is a good point - it's possible that I may actually have HSA coverage as late as July.  In regards to 2017, thank goodness, I'm not actually at the limit as I'd considered doing, so that helps me significantly.

[dmertz]

As I said in response to your related question, any contribution that was permissible under the last month rule does *not* become an excess contribution if you fail to satisfy the testing period.  There will be no excess contribution from 2017 to apply as a 2018 contribution.