HSA - Tax & Penalties - To Withdraw Now or Later?

[bk44]

In July 2020, I instructed my HSA custodian to make the max deductible contribution ($4500 for a 60 yr old) to my pre-existing HSA account  for TY 2019 because for the entire month of December, 2019, I was enrolled in a HDHP  (Self Only Plan). 

In 2021,  preparing TY 2020 tax returns I realized that the failure to maintain HDHP coverage in 2020, resulted in an excess contribution  of $4125. 

I did not have HDHP coverage at all in 2020.

On December 31, 2020 the balance of that HSA account was $11,600 

Considering the following:

I don't expect to  enroll in a HDHP in 2021 or the following years, but that may change?

I don't expect to have enough qualified medical expenses to exhaust and empty the HSA anytime soon.

I do turn 65 in 2025

I have yet to file my 2020 taxes and plan to request an extension

I'm still unclear about the current & future ramifications of  withdrawing the excess $4125 now or later (maybe 2025)?

If I understand correctly, in TY 2020 that $4125 is subject to both a Federal 10% penalty and 6% tax?

Does New York State/NYC also impose any tax or penalties on all or part of that $4125?

If in 2021, I withdraw that $4125 (and any earnings):

Am i correct that withdrawal will result in a 20% penalty in TY 2021 for a non-qualified distribution?

In TY 2021, would that $4125 also  be subject to the 10% penalty & 6% tax or any other taxes/penalties? 

Beginning  TY 2022, is the excess contribution matter now closed and no longer subject to any related taxes, fees, and/or penalties?

OTOH:

If that $4125 stays in the HSA, I presume that  in TY2021 that $4125 is subject to another 6% tax ($247.50)  and that 6% repeats each following year that $4125 remains in the HSA account?

Are there any other additional taxes, penalties  that accrue each TY the $4125 remains in the account?

Finally:

Is there any benefit to waiting to withdraw the $4125 in TY 2025, once I turn 65?

THANKS!

[BillM223]

"I realized that the failure to maintain HDHP coverage in 2020, resulted in an excess contribution  of $4125."

First, an important terminology note: failure to maintain HDHP coverage is NOT the same as excess contributions.

When there is a failure to maintain HDHP coverage, then the amount that you would not have been able to deduct but for the last-month rule is added to Other Income on line 8 of Schedule 1 (1040). In addition, on form 8889, an additional 10% of that amount is calculated. So you pay income tax on the amount you "over-deducted" plus a 10% penalty.

HOWEVER, because this is not an excess contribution, you don't have to withdraw anything. You are now done with it.

As for what you do with it, the best thing is to withdraw that HSA money only when you have qualified medical expenses. While it is true that once you turn 65, you can make penalty-free withdrawals, the withdrawal will still be added to your income to be taxed (just like an IRA). I have to believe that in the next few years, you will find plenty of qualified medical expenses to spend it on, and that will all be tax-free.

[bk44]

Thanks for the reply & clarification that failure to maintain HDHP coverage is NOT the same as excess contributions.

Are you saying that for TY 2020, the10% tax levied on the amount of the 2019 HSA contribution for those 11 months ($4125) I was not covered by an HSA is the ONLY  tax, fee or penalty incurred? 

Assuming I pay that 10% in 2020 and leave the total $4500 2019 contribution in my HSA, going forward, for TY 2021 and beyond,  NO taxes or penalties associated with making that 2019 HSA contribution will accrue? The matter is truly closed?

If that's the case, why in TY 2020, does TurboTax  (Form 5329, Line 49)  indicate I ALSO owe 6% ($248) on that  11 month HSA deduction ($4125)  I was not entitled to?

Is that 6% tax ONLY for TY 2020 or will that continue going forward?

Alternatively, is the TY 2020 ADDITIONAL 6% tax the result of an incorrect entry during the step by step interview?  If so, I'm not sure where I made a wrong entry?

I truly appreciate your assistance! Thanks!

[BillM223]

"Are you saying that for TY 2020, the10% tax levied on the amount of the 2019 HSA contribution for those 11 months ($4125) I was not covered by an HSA is the ONLY  tax, fee or penalty incurred? "

No, as I noted, the amount that should not have been deductible in 2019 (except for the last-month rule) was added to your income to be taxed AND there was a 10% penalty on top of that.

"The matter is truly closed?"

Yes.

"If that's the case, why in TY 2020, does TurboTax  (Form 5329, Line 49)  indicate I ALSO owe 6% ($248) on that  11 month HSA deduction ($4125)  I was not entitled to?"

There are two different things happening.

1. You possibly used the last-month rule in 2019, which gave you the full annual HSA contribution limit.
2. Then you in 2020 did not have HDHP coverage for the full year.

For #1, you had to maintain HDHP coverage for all of 2020, but you didn't. This gives rise to the "failure to maintain HDHP coverage" with the 10% penalty.

For #2, if you continued to make contributions in 2020 at the same rate as 2019, but suddenly did not have HDHP coverage, this not only gave rise to the failure to maintain HDHP coverage in 2020, but it also likely gave rise to excess contributions for 2020.

Example:

I contributed through my employer $6,000 to the HSA in 2020. But I maintained HDHP Family coverage for only Jan, Feb, Mar. So this is an excess contribution for 2020 of $4,225. This appears on form 8889 on the line 12 Smart Worksheet (which you may not be able to see unless you have the CD/download software). It is also add to line 8 of Schedule 1 (1040) as Other Income.

This amount also carries to the 5329, line 47 and 48, where it is assessed an additional 6% ($254, because I did not withdraw it by the due date of the return). This $4,225 then is also being carried over to 2021. The penalty of $254 appears on 5329, line 49, and is added to Schedule 2 (1040), line 6.

When I answered that I had Family coverage on December 1, 2019, then I went through the steps to determine any penalty for failure to maintain. I answered that I had Family coverage only for December of 2019, and I contributed $5,000 for 2019.

Because I had coverage for only one month in 2019, I would have contributed only $583. Therefore, the other $4417 should not have been contributed, and it is not only placed into Other Income (line 8, Schedule 1 (1040)) to be taxed, but it also appears on line 47 of form 8889, to be hit with that 10% penalty (line 21 on the 8889).

So now we have two things that have gone into line 8 of Schedule 1 (1040), the $4,225 excess contribution for 2020, and the $4,417 of the "would have been excess, but is really a failure to maintain HDHP coverage" for 2019, for a total of $8,642.

But ONLY the excess for 2020 (the $4,225) is on form 5329, line 47 gets the 6% penalty and is carried over to 2021. The failure to maintain amount (the $4,417) is NOT hit with the 6% penalty, nor is it carried over to 2021.

Yes, this is complicated, but you likely have two amounts at once: the excess for 2020 and the failure to maintain from 2019...but only one of them is dinged 6% and carried to the next year.

Work through return and see if this happening on your return.

[bk44]

re:  "If that's the case, why in TY 2020, does TurboTax  (Form 5329, Line 49)  indicate I ALSO owe 6% ($248) on that  11 month HSA deduction ($4125)  I was not entitled to?"

There are two different things happening.

1. You possibly used the last-month rule in 2019, which gave you the full annual HSA contribution limit.
2. Then you in 2020 did not have HDHP coverage for the full year.

Yes, as indicated in #1, I  did use the last month rule in making a "full-year" HSA contribution for TY 2019. ($4500)

" For #2, if you continued to make contributions in 2020 at the same rate as 2019, but suddenly did not have HDHP coverage, this not only gave rise to the failure to maintain HDHP coverage in 2020, but it also likely gave rise to excess contributions for 2020."

I appreciate your patience, but despite  reading your example I'm still confused why in TY2020 I am also subject to the 6% tax?

I did NOT make any HSA contribution for  TY2020.  The only contribution made to my HSA was for TY 2019 (Total  $4500 of which only 1 month, December 2019, was allowed.)

Is the reason that 6% tax is levied in TY2020 because:

A. I failed to maintain HDHP coverage in TY2020 or

B. I made an incorrect TurboTax interview response that somehow resulted in the program reflecting a HSA contribution for TY2020? or

C.  both A and B or something else?

Finally, if for TY2020 I must pay BOTH the 10% tax ($413) and the 6% tax ($248) to correct my actions of that singular $4500 HSA TY 2019 contribution , will that close this matter?

In other words, once both those TY 2020 taxes are paid on the 11 months I failed to maintain HDHP coverage ($4125), going forward  in TY 2021 and beyond, no taxes or penalties will continue to accrue due to that TY2019 HSA contribution?

Thanks so much!

[Opus 17]

@bk44 

@BillM223 

I have not worked all the number and only skimmed the scenario, but I think I can answer some of your confusion.

The amount paid for the 2019 year, which became non-eligible due to the failure to maintain coverage under the last month rule, is subject to income tax plus a one-time 10% penalty.  You don't say how many months you were covered by an HDHP, but it was at least one month, so possibly $4125 is ineligible.  If you had qualifying HDHP coverage for other months of 2019, the disallowed contribution would be less. 

Any amount contributed during 2020 toward TY 2020 would be non-eligible, is considered an excess contribution, and is subject to regular income tax plus a 6% penalty this year.  Every year that the excess remains in the account, it will incur an additional 6% penalty. 

However, you said that you made no contributions in 2020 toward TY 2020.  It seems that Turbotax thinks you did make contributions toward TY 2020.  I would re-visit the entire HSA interview and make sure you did not indicate you made a 2020 contribution.  If you did not indicate a 2020 contribution, then either your file has an error, or Turbotax has a programming glitch (although it worked correctly in Bill's test.)

If you are using the program installed on your own computer, we may be able to look at the forms and worksheets to find where the incorrect 2020 contribution is coming from.  If you are using TT online, you don't have direct access to the worksheets so you would have to call customer support so they can examine your file directly, or possibly clear your return and start over, and see if the problem comes back when you re-enter your information. 

[bk44]

You are correct that in TY 2019 I only had HDHP coverage for 1 month, December, 2019.

Consequently in TY 2019,  I was ineligible  to contribute S4125.00 of the total $4500 contributed/deducted.

To date, the remaining balance of that TY 2019 contribution ($4125) remains in my HSA.  

Please confirm/correct  my understanding  that,  given NO TY 2020 contribution was made, that $4125 does NOT trigger a 6% penalty for each year it remains in my HSA?

I am using the desktop version of  TT Deluxe but first will  redo the entire  HSA interview as I did NOT make any HSA contribution in TY 2020!

Thanks so much!