HSA Contributions: I will fail the 2018 testing period - can I withdraw my "excess contributions" without penalty before the 2017 deadline?

[Anonymous]

I know I will fail the testing period because I am changing jobs and getting a new (lets say HMO) plan in a few months.  But I completely misunderstood the last month rule and added a lot of money that I shouldn't.  Lets use examples and say it was the final 3 months of 2017, and I added $100 extra.

Accordingly, I plan to

1. Adjusting my total eligible contributions manually on 8889-T
2. Calculate an $850.00 maximum allowable contribution, since I will fail the Last Moth Rule testing period in 2018, requiring a full year of eligible coverage.
3. File with my HSA account custodian to receive an excess contribution distribution.
4. Receive a 1099-SA with code 2, indicating the distribution as income.
5. Add the 1099-SA with code 2 to TurboTax as 2017 taxable income.
6. Pay my taxes on the newly reported/reclassified income.
7. Complete all of the above steps prior to the 2018 filing date of April 17th.

I should be penalty free, right?

However!  I've also read (and heard from my HSA company!) a different opinion: as long as I have healthcare for the testing period, I'm in the clear.  As in, "Oh, it's not my fault the healthcare options changed."

Here's the official publication I've found on the matter.  https://www.irs.gov/publications/p969

Edit: I thought of another, easier way to summarize the question.

I will have HDHP coverage from October 1st 2017 through May 31st 2018.  I will have HMO/PPO coverage for all other months.  What are my maximum allowable contributions for 2017 and 2018?

[Anonymous]

I thought of another, easier way to summarize the question.

I will have HDHP coverage from October 1st 2017 through May 31st 2018.  I will have HMO/PPO coverage for all other months.  What are my maximum allowable contributions for 2017 and 2018?

[dmertz · Accepted solution]

Any amount you were eligible to contribute under the last month rule does not become an excess contribution because you fail to satisfy the testing period.  You simply owe a 10% recapture tax (on your 2018 tax return in this case) on the amount that you contributed that was in excess of the amount that you would have been eligible to contribute were it not for the last-month rule.  Unlike IRA contributions, only actual excess contributions are permitted to be returned to you in this way.  Because this amount is not an excess contribution, you are not permitted to have it distributed back to you as a return of excess contribution.

If you request a return of excess contribution from the HSA custodian, the custodian will likely take your (untrue) word for it that you were ineligible to make the contribution and make the distribution that you request.  If the IRS later audits and discovers that you were HSA-eligible for December, the IRS will treat the amount improperly obtained as a return of contribution as a regular distribution instead, subject to tax and (if under age 65) 20% penalty, as well as hitting you with the 10% recapture tax.

[Anonymous]

So I guess the only question is how do I get out of this situation?  The contributions were made last year, and I have not filed my taxes - how can I correct this without a penalty that exceeds my normal taxation rate?

[dmertz]

Your choices are to tell the HSA company that you made an excess contribution and ask them to make a return of excess contribution (even though you made no excess contribution; I am not advocating this), or pay the 10% recapture with your 2018 tax return for failing to remain an eligible individual through the testing period.

[Ignore the following paragraph.  The 10% recapture is in *addition* to income tax that must be paid on this amount in 2018.]
Note that the 10% recapture tax will be less than the income tax you would pay as a result of the return of excess contribution if your marginal income tax rate for 2017 is above 10%.  For most people, there is no monetary advantage to fraudulently requesting a return of excess contribution when they made a proper HSA contribution under the last-month rule.

[dmertz]

Oh, and failing to complete the testing period means failing to remain eligible to make an HSA contribution corresponding to each month of the entire testing period.  Simply maintaining just any kind of health insurance is *not* sufficient.

[Anonymous]

Thank you.  I worry about that, because on this page <a rel="nofollow" target="_blank" href="https://www.irs.gov/instructions/i8889">https://www.irs.gov/instructions/i8889</a> I see that the IRS specifies this 10% recapture as an additional tax, which would mean it is a penalty tax on top of the regular marginal tax rate, which is what I'm trying to find a way out of.  I also see this on Publication 969 in testing period paragraph 2.

[dmertz]

I'm sorry, you are right.  I forgot that you owe both income tax *and* 10% additional tax on the amount you would not have otherwise been eligible to contribute.  Ignore what I said about 10% being less than your marginal tax rate.  Keep in mind, though, that income tax rates are lower for 2018 than for 2017 due to the recent tax-code changes.

[Anonymous]

Dmertz, can you please resubmit your final reply as a new answer so I can mark it?