I contributed to an HSA for years while wife had HRA. How to make this right?

You are ineligible to contribute to an HSA if you have "other" medical coverage.  A typical HRA will cover the employee, spouse, and dependents, so that counts as "other" coverage and disqualifies you from making HSA contributions.  If the HRA was "frozen" so that it couldn't be used for expenses, then it is not "other coverage" for as long as it is frozen, but that means giving up the HRA which is probably free money, so you need to think if you really want to do that.

You need to contact your employer to stop your ongoing HSA contributions, but they don't "reclassify" the prior contributions as wages.  Nothing changes about the past wages, W-2, etc., you just need to change your contributions going forward.

For 2021, if you were enrolled in a self-only HDHP, your contribution limit was $300 per month, or $600 per month if enrolled in a family HDHP.  Eligibility is determined by your coverage on the first day of each month (and I am assuming you are under age 55).  So you need to get a calendar and figure out how many months you were eligible to make contributions and what your dollar limit was.  If you contributed over the dollar limit, that's an excess contribution.  It is too late to remove the excess contribution to avoid a penalty, so what will happen is you will file an amended 2021 return showing the excess contribution.  It gets added back to your taxable income, plus a 6% penalty.  (The penalty is based on the amount of excess or the account balance at the end of the year, whichever is less, so if you have been spending the account as you go, you might not actually owe much penalty.)

(Also note that your limit is a dollar amount, not based on time.  If you were covered by a family HDHP for 4 months before the HRA started, your limit would be $2400. If you contributed $300 per month for 6 months, including months after the HRA started, your limit would be $1800 and you would not be over.)

For 2022, we need to consider if you already filed a return, are late but have an extension, or are late with no extension.  Here I will assume you already filed your 2022 return.  If it is one of the other two, post back because your actions and options may be different. 

For 2022, your contribution limit was zero, assuming you were covered by the HRA all year.  It is too late to withdraw the excess funds without penalty.  You will file an amended return to report the excess contributions.  They will be added back to your income tax, plus a 6% penalty on the cumulative excess contributions (from 2021+2022).  As before, the penalty is based on the amount of excess or the account balance at the end of the year, whichever is lower, so if you have been spending the account as you go, you might owe less than you expect.

For 2023 you need to first, stop the excess contributions.  Second, contact the HSA bank and ask for a "return of excess contributions"--but you can only get a return of the 2023 contributions, it is too late to return any of the prior year contributions.  It sounds like that would be about $1500 for 2023 so far.  At tax time, that amount will be added back to your taxable income, but you won't be charged an additional penalty.

However, on your 2023 tax return, you will be charged another 6% penalty on the remaining balance of excess contributions from 2021 and 2022.  There are 3 ways to avoid this penalty.

1. Spend the HSA for qualified medical expenses.  (The penalty is based on the amount of excess or the account balance at the end of the year, whichever is lower, so if you spend the funds on qualifying care, the penalty will be lower.)
2. Withdraw the excess funds not for qualified expenses.  You will pay income tax plus a 20% penalty, but you will stop the ongoing 6% penalty.
3. Become eligible again to make HSA contributions, and use your new eligibility to "use up" the prior excess.  For example, suppose your wife changed her insurance so that you were eligible.  Your limit for 2023 could be as high as $3850 for self HDHP and $7750 for a family HDHP.  You would apply your excess against the new limit to "use up" the excess.

Now, a bit more detail about 2023.  If your wife freezes the HRA, and if you are eligible to make HSA contributions on 12/31/23, and if you remain eligible to make HSA contributions for all of 2024, then you can use the "last month rule" to contribute the maximum amount to your HSA in 2023 as if you were eligible all year even though you were not.  

If you decide the HRA is pretty good and you don't want to freeze it, then you need to look at your financial circumstances to determine the best way to handle the excess.  If you will spend your HSA down to zero in the next 3-4 years, paying 6% per year on the excess as it dwindles may likely be cheaper than paying 44% tax on a non-qualified withdrawal (22% income tax marginal rate plus 20% penalty). 

Lastly, because you will owe tax payments on your amended return, the IRS will likely assess interest and a late payment penalty.  If your tax provider wants to include the penalty and interest, I would suggest to them that you don't pay the interest and penalties up front but wait for the IRS to bill you.  Once you get the bill, you can apply for a waiver of the penalty for cause, or as an administrative waiver if you are a first-timer (never paid a penalty before).  By law the interest can't be waived, but if they waive the penalty, they will recalculate the interest to be a little lower. 

Thanks Opus. This is very informative and helpful! Though, unfortunately, it seems the quickest way to address this is also the most expensive (i.e. withdrawing everything and washing my hands of this whole ordeal)

You are right that I'm under 55. I have not spent anything out of the HSA so far. Though, my wife and I recently had our first child, so your option A, paying for all the medical expenses from the HSA may be a good option for us! I didn't know you could still use the HSA even if the contributions are ineligible. Are there any pitfalls in doing this?

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@MrHarriet wrote:

Thanks Opus. This is very informative and helpful! Though, unfortunately, it seems the quickest way to address this is also the most expensive (i.e. withdrawing everything and washing my hands of this whole ordeal)

 

You are right that I'm under 55. I have not spent anything out of the HSA so far. Though, my wife and I recently had our first child, so your option A, paying for all the medical expenses from the HSA may be a good option for us! I didn't know you could still use the HSA even if the contributions are ineligible. Are there any pitfalls in doing this?

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Quickest isn't always cheapest.

Once you have money inside an HSA, you are free to spend it tax-free for qualified medical expenses for yourself, your spouse and your dependents, even if you are not eligible to make new contributions. 

Also, you can withdraw funds to reimburse yourself for any qualified medical expenses you had at any time after the HSA was opened, even if you chose not to use the HSA at the time.  (You just can't reimburse yourself for expenses that were covered by insurance or the HRA because that would be claiming 2 tax benefits for the same expense.)  So you could now withdraw money to reimburse yourself for any out of pocket expenses (co-pays, prescriptions, and so on) going back to mid-2021.  And you can continue to withdraw money to pay your out of pocket expenses through Dec 31, 2023.  Then at the end of December, you can decide whether to make a clean break of it and withdraw the remaining balance and pay 44%, or leave the remaining balance and pay 6% and carry it to next year.   Just be sure to initiate any withdrawals a few days before 12/31, because the withdrawal will count when the bank processes it, not when you request it, and if there is a bank delay at the end of the year, you could have a 12/31 withdrawal that is not actually processed until 1/3/24. 

On your 2023 tax return, you will be asked for your total withdrawals, that will be reported on a form 1099-SA that the HSA bank will send you.  Then you will be asked if you used all the money for qualified medical expenses, if the answer is no, you will enter the total of medical expenses and Turbotax will assess the penalty on the rest. 

Thank you again, Opus! I have given this more thought. I think the main question now is, when does the IRS consider the excess contribution eliminated? It seems in all these scenarios, the end goal is to draw the HSA down to $0 and never have an HSA again in my lifetime – which is not necessarily the goal. Quite the opposite, I would like to have a nice sized HSA balance when I retire.

I looked at the instructions for Pub 969 and Form 5329, but can't make sense of it. It's not clear to me if withdrawing funds for medical expenses, like we discussed, would be applied in the same way as withdrawing an excess contribution. Nor is it clear whether it's treated as first-in, first-out (like selling a stock), or how I would know when my account is no longer tainted.

There is an interesting note in Form 5329, and I wonder if it would apply in my case:

"If you timely filed your return without withdrawing the excess contributions, you can still make the withdrawal no later than 6 months after the due date of your tax return, excluding extensions. If you do, file an amended return with “Filed pursuant to section 301.9100-2” entered at the top."

If my goal is to get this straight with the IRS and continue contributing to my HSA, what do you think the best approach would be? I really appreciate all your help with this.

If by April 18, 2023 you filed your tax return or requested a filing extension, yes, you have until October 16, 2023 to request a return of the excess contribution made for 2022.  The HSA custodian will make a distribution of the excess adjusted for investment gain or loss to accomplish the return of the amount that you request to be returned.

You'll still owe with your 2022 tax return a 6% penalty on the excess contribution made for 2021.  To eliminate that penalty for 2023 you'll need to make a regular distribution equal to the amount of the excess, with no adjustment for investment gain or loss, and treat that distribution on your 2023 tax return as taxable (not used for qualified medical expenses).  In addition to income tax (which you will effectively be paying twice on this money due to having to include it in income on your amended 2021 tax return), the distribution will be subject to a 20% extra tax as described by Opus 17..

@MrHarriet 

I forgot about the special rule for withdrawing HSA funds after the tax deadline (as long as you file an on-time return) and reporting it on an amended return with the special instructions. Because of the requirement to add a written statement, you won’t be able to e-file your amended return.  Don’t make a regular withdrawal from the HSA, request a “return of excess contribution.“  If you earned any interest or dividends on the excess contributions, they must also be returned to you, and that will be reported as taxable income on your 2023 tax return.

You must still amend your 2021 return to pay the penalty on the excess contribution for 2021, and because that excess contribution is still in your account at the end of 2022, you will pay another 6% penalty on that amount on your amended 2022 return, even though you will remove the 2022 excess contribution.

As I mentioned before, you have several options on how to remove the 2021 excess contribution.  You can withdraw it as a non-qualified withdrawal and pay regular income tax plus a 20% penalty.  Based on your scenario, I believe the excess would be $600, so the tax and penalty will be somewhere around $250.  Or, you can leave the excess in the account and pay the 6% penalty year over year until you become eligible to make contributions again, in which case you can use up the excess by counting it toward your new contribution limit. 

HSA accounts don’t follow FIFO rules, if you have $600 of excess in the account today, and you don’t perform the procedure to remove it or use it up, it will be penalized as long as you have any funds in the account.  However, this doesn’t remain with you forever. If you were to spend the account balance down to zero in the next couple of years (because you have a new baby and you choose to spend the account on out-of-pocket medical expenses) then once your account has a zero balance, the excess is considered removed. The excess does not reappear once you become eligible to make new contributions again.  You “get straight” with the IRS by either withdrawing the excess contribution as a taxable, non-qualified distribution, or by spending your account to zero on non-taxable qualified medical expenses, or by applying the excess to your new contribution limit if in the future you become eligible again.  

It seems a shame to spend $250 this year on taxes and penalties with a lump sum non-qualified withdrawal, when you would only have to pay $36 a year in penalties if you left the money in the account. I guess it depends on what medical expenses you think you will have and how your insurance coverage might change over the next 5 years.  

My wife called her HRA provider today, and they said I am not listed as a dependent on her HRA but can be added as a dependent easily by my wife. I am wondering (perhaps overly optimistically) whether me not being listed as a dependent is enough to make this a non-issue, or if it is still a problem because my wife could add me at any time. (They also noted some accounts the spouse needs to be "linked", but with the way her employer set it up, linking is not necessary.)

If this makes no difference, and if we're still on the hook for my HSA contributions, I am wondering, who should I talk to that will be knowledge enough about the intricacies about all of this to address everything appropriately? It seems like a very specific topic, and we want to be sure we have a hire a tax professional who understands everything, including the special six-month rule that requires a written statement.

@MrHarriet 

If your wife's HRA allows coverage for spouse and dependents, then I think you are considered covered.  It would be one thing if the employer had a strict "employee only" policy.  I don't think it would be satisfactory to say that because you never activated the coverage, you were never covered, if it was available for you to activate at any time.  If you want to rely on that lack of activation to not report your HSA contributions as excess, I would get a professional opinion.

As far a finding a suitable accountant is concerned, you have to interview them and make sure their skills match your needs.  You can look for an "enrolled agent," which is a designation applied to accountants who are specifically enrolled to practice before the IRS, but there may be many accountants who are not EAs who would be qualified to deal with your situation. 

Being listed as a "dependent" or not does not change that fact that the HRA can be used to reimburse expenses for your medical care as spouse of your wife.

@Opus 17 @dmertz I appreciate all of your help through this. I expect to find out definitively next week whether the HSA was ever frozen or not, and will take correction action if it wasn't (which I believe is most likely the case)

Based on my understanding, I have over-contributed the following:

2021: 475.01 (not including $1,200.00 from July-Oct that was eligible at the time)

2022: 3600.00

2023: 1200.00 (so far)

To my understanding, I could withdraw my 2021 excessive contribution as an unqualified withdrawal (and pay the 6% excise tax on it for 2021 and again for 2022, the 20% penalty on an unqualified withdrawal, plus ordinary income tax), then withdraw the 2022 and 2023 excessive contributions as excessive contributions (and only pay income tax on it), and submit my amended 2021 and 2022 returns accordingly. If I were to do this, and nothing else, I assume I could still theoretically leave the $1,200 from my eligible months in 2021 in the account (right?)

However, what I still don't understand is, if I were to withdraw - let's say - $2,000 this year for qualified medical expenses incurred this year, then which year's contributions would that be considered taken out of? Or would it at all? If I can get away with simply paying a 6% excise tax on this amount, rather than ordinary income tax, that would seem more prudent, right? But then how in the heck would the IRS consider the interplay of correcting my over-contributions each year with the withdrawals for medical expenses in 2023? Would I simply do what I described in the previous paragraph, and then withdraw any remainder down to $0 (for 2023) as an excessive contribution?

Alternatively, in a scenario where I have - let's say - $4,000 in medical expenses this year, and I use HSA funds to cover it, would the IRS's special six-month rule still apply for 2022 (even though I wouldn't be able to withdraw all of the excess contributions I made in 2022) or would I get dinged for not being able to withdraw the full $3,600 in ineligible contributions for that year?

Distributions other than a return of excess contribution before the due date of the corresponding tax return (including extensions) are not allocated against any particular amount in the HSA.  In HSAs there is no separation of the funds into various groups  (other than prior-year excess contributions, current-year excess contributions, and other amounts).

The 6% penalty for an excess contribution not returned before the due tax of the corresponding tax return is assessed every year until the year the excess is corrected or the balance in the HSA drops to zero.

@MrHarriet 

The excess contribution is always there unless it is removed in one of the allowed ways.  Think of it this way, suppose you have a balance of $5000 with $4000 of excess contributions and $1000 of allowable contributions, and you spend $4100 on medical care leaving you a balance of $900.  That $900 is all excess, because if it were not for the excess, your balance would be zero.

Side note, if you were contributing $300 per month, your excess for 2021 should be $300 or $600, I don't see where $475 comes from.

You have several scenarios, I will deal with the two extreme scenarios.

If you want to remove all excess balances, this is what will happen in chronological order.

1. File an amended 2021 return to report your change in insurance circumstances. The excess contribution will be added back to your taxable income plus a 6% penalty.  You must do this first because you need information from your 2021 return to amend your 2022 return, no matter what you plan to do.
2. Remove $3600 from the HSA as a return of excess (the 2022 contributions).  Then, prepare and file an amended 2022 return to report the excess and indicate you removed it.  The excess will be added back to your taxable income but you will only be assessed a 6% penalty on the $475 excess from 2021 that is still in the account.  This amended return must be mailed, not e-filed, and you write "pursuant to..." on the top of page 1.
3. Remove $1200 from the HSA as a return of excess (the 2023 contributions). Withdraw another $475 not for medical expenses.  On your 2023 tax return, you will report the contributions (because they will be on your W-2) and you will say you removed them before the deadline.  They will be added back to your taxable income.  Then you report your HSA withdrawals from form 1099-SA.  You will be asked "did you use all the money for qualified expenses" and you will answer no.  Then you will be asked for details and you will report that $475 was non-qualified.  That amount will be assessed regular income tax plus a 20% penalty, and it will remove the excess designation from your account, so that even if you have a remaining balance (the $1200 allowable contributions minus any spending for medical costs) it is not accounted as excess and not assessed another 6% penalty.

Suppose you leave all the money in the account and you have $4000 of expenses this year, this is what will happen in chronological order.

1. File an amended 2021 return to report your change in insurance circumstances. The excess contribution will be added back to your taxable income plus a 6% penalty.  You must do this first because you need information from your 2021 return to amend your 2022 return, no matter what you plan to do.
2. File an amended 2022 return to indicate you were not qualified for HSA contributions.  Turbotax will add the $3600 back to your taxable income and assess a 6% penalty on $4075. This amended return could be e-filed. Your balance is now $5275 with $4075 considered excess.
3. For 2023 you stop your contributions but don't withdraw them.  Your balance is now $6475.  You withdraw $4000 for qualified medical expenses.  On your 2023 tax return, you will report the contributions (because they will be on your W-2) and you will say you did not remove them.  You report $4000 of qualified medical expenses. The withdrawal is not taxed.  Your remaining balance is $2475, which is all considered excess, and will be subject to a 6% penalty.

What I would suggest is likely to result in the lowest overall taxes and penalties is to start by amending 2021 reporting the excess and paying the tax and penalty.  You must do this regardless of any next steps.  Your second step would be to remove the 2022 excess and file an amended return using the write-in procedure. You also need to stop future contributions.  At that point you would have a balance of $2875 of which $1675 is excess.   (The 2021 excess, 2023 excess, and 2021 allowable amount).  I would then think about your likely medical expenses for 2023.  If they will be more than $2875, then leave the account alone and withdraw money as needed for medical expenses.  Be zeroing out the account by the end of the year, you will eliminate any future penalties.  If your expenses will be between $1675 and $2875, then remove the $1200 2023 excess as return of excess contributions, but leave the 2021 excess alone, because you will use it up.   If your expenses will be less than $1675, then you have to decide whether to withdraw $475 not for medical expenses and pay $209 in tax and penalties and be done with it, or leave it in the account and pay $29 and plan to use up the money in the future. 

@Opus 17I'm following up on this, in case it can help somebody in the future. We sent a couple support questions to my wife's HRA provider to confirm whether the account definitively made me HSA-ineligible, just to be sure, and will hopefully know soon.

I also contacted my HSA provider about this matter. They were very helpful (Lively) and confirmed they can process an "excess contribution reversal" and provide an amended 5498-SA for my 2022 excess contributions. For 2023, they can perform the same reversal and clear the reporting altogether as if they never happened. (Of course, I'll still have to pay income tax.) For 2021, they said they can process an "excess contribution withdrawal" which will appear on my 2023 1099-SA. 

They also said I should contact my employer to see how they would like to process the ineligible HSA contributions (since they were made as pre-tax payroll contributions). It sounds like, at least for 2022 and 2023, it all depends on whether they want to recoup their $25/paycheck or just wash their hands of this and let me keep it as taxable income (which sounds like what most employers do). Whether or not they will be reporting the transactions will affect both their and my tax reporting.

Also, I contacted two separate tax preparers (I had always done my own taxes) and was honestly a little put off by both of them. I was surprised that they both sounded cavalier about whether or not the issue is worth addressing at all. (I will address it.) They were also booked for weeks before they could begin to prepare my forms. But the main thing was that I felt more knowledgeable about the problem and how to solve it (now after reading your replies, reviewing the IRS forms and instructions, and communicating with my HSA provider), that I plan to prepare and submit the amended tax forms myself. One tax preparer quoted me a minimum of $800, with no cap, as they would charge $400 each year to enter everything into their system, plus extra for an additional state return, extra time, the possible paper submittal, etc. It sounded like over $1000, which almost certainly exceeds what I will pay for the tax itself. I will continue providing updates in case it helps anyone in the future.

@MrHarriet 

The HSA Bank cannot legally process an excess contribution withdrawal for 2021 contributions after October 15, 2022. If they process an excess withdrawal for you, then they are either breaking the law, or they are making a regular withdrawal not for medical purposes, which will subject the withdrawal amount to income tax plus a 20% penalty. 

Whether or not you owe anything to the employer for the $25 per week that they were contributing to your account is a matter between you and your employer. The IRS doesn’t care, and the HSA Bank has no business giving you advice in that area.  From the IRS point of view, the ineligible contribution is added back to your taxable income, as if it was a $25 per check raise or bonus that was included in your taxable income all along.  The HSA bank will not be returning the funds to your employer, they can’t. They can only return funds to you, because the account is owned by you and all funds in the account belong to you after they are contributed.

There might have been an implicit understanding with your employer that you were eligible for the HSA, and they would only make contributions if you were eligible. There might also have been an explicit contractual arrangement with your employer.  On the other hand, you are not the first person to enter an agreement in good faith without realizing that their spouse had insurance arrangements that conflicted with the HSA requirements.  I don’t feel there is any need to bring this up with your employer or offer to pay them back the $25, but that is up to you.  There is no legal requirement in state or federal law that would require you to bring this to their attention. Any requirement to correct this with the employer would be a matter between you and the employer only.

@Opus 17Another update: After much back-and-forth with my wife's HRA provider, I have concluded there is no indication the HRA is anything special, and that my HSA contributions have indeed been ineligible. As such, I have initiated a removal of the contributions through my HSA provider.

The HSA provider has since asked me a series of questions. The two main questions are exactly how much should be removed for each year, and whether there are any earnings I need to report. For the amount to withdraw each year, here is what I figured:

2021: 475.01 because I was eligible for four months (July-Oct), and a total of $1,675.01 was contributed during the calendar year. This includes some money contributed after I became ineligible in November, but that's perfectly okay because it's all based on a person's limit for the entire year (in this case $1,200) correct?

2022: $3,600

2023: $1,800

The second question is trickier. They want to know if I have any earnings on my contributions. I only purchased investments with my HSA contributions in 2021 and 2022. I stopped investing after 2022 because of the baby on the way. A couple months ago, I sold all of the investments for a net loss of about -3%. However, here is what I don't understand: Does the amount of "earnings" depend on the year of the sale (in the same way a taxable brokerage account is taxed)? Or, does it depend on the year the investment is purhcased? If I separate it out by year, the investments I purchased in 2021 were sold at a loss of -$185.80 (every "buy" order in 2021 was sold in 2023 for a loss). But the investments I purchased in 2022 were sold at a net gain of $44.96 (about half of the "buy" orders were sold in 2023 for a loss, and half for a gain). Do you know how the IRS would calculate this for the purposes of removing excess HSA contributions and earnings?

(As a side note, I did inform my employer about this situation, and they were uninterested in getting anything returned to them.)

Each year's corrective distribution is determined separately.

The excess contribution for 2021 must be corrected by obtaining a regular distribution of $475.01, made taxable by not applying it to nay medical expenses.  This distribution will also be subject to a 20% penalty for distribution before age 65.

As long as you filed your 2022 tax return or obtained a filing extension by the regular filing deadline for your 2022 tax return, you have until October 16, 2022 to obtain a return of excess contribution.  CFR 1.408-11 details the process for calculating the attributable gain of loss that must accompany the distribution.  The calculation period begins on the date that you first made a 2022 HSA contribution and ends on the date of the corrective distribution.  Normally the custodian should be doing the gain/loss calculation because the account value can fluctuate, but if your account is presently invested in a way that that value does not fluctuate, you can do the calculation yourself.  Note that the calculation is based on the overall value and performance in the account, not on the value of any particular investment in the account.

You can similarly obtain a return of the excess contribution for 2023 because it is well before the due date of your 2023 tax return.

I'm not sure, but the gain/loss calculations will vary a bit depending on whether you obtain the $475.01 distribution before or after the returns of the 2022 and 2023 excess contributions, so you might want to do the calculation both ways.

Thanks @dmertz. Though, this seems wildly complicated and raises more questions than it answers! For example, does a gain/loss calculation need to be performed for 2023, even though I never invested any of my 2023 contributions, since it depends on the value of the HSA rather than the investments?

I gave an overview of this situation to my custodian and asked if they can calculate the gain(s)/loss(es) for each year. But since the asked me for those values, I don't have confidence they'll be able to help. In which case, I am truly at a loss. I know I owe the IRS some amount of money, but with this gain/loss issue, I can't have any confidence that any amounts that I calculate would be accurate.

If my custodian can't help, then it's almost tempting to reinvest my HSA in some terrible investments, just to lose more money so I can avoid these calculations altogether. OR, just forget any tax benefit whatsoever, have everything distributed as a normal distribution, and pay the maximum penalty (20% plus the 6% each year) to make this go away. But even in that case, I would still need to figure out a number to report for any gains, right?

Can you tell me what the easiest method would be to resolve this, assuming I don't care about how much it costs? I feel so frustrated and beaten down by this process.

The gain/loss calculation must always be done for a return of contribution before the due date of the tax return.  The fact that an amount equal to the money deposited as 2023 contributions remained uninvested is irrelevant.  What is relevant is the overall investment performance in the HSA.  Once deposited into the HSA, the 2023 contributions are no longer independent of the other funds in the account.  If any part of the HSA is invested, there will be a nonzero gain or loss attributable to the 2023 contributions.

Losing money in the investments doesn't help.  To be a valid return of contribution the gain/loss calculation must be done.  If more than the loss-adjusted amount is distributed, the amount in excess of the loss-adjusted amount constitutes a regular distribution that you can either apply to qualified medical expenses or you can treat as taxable and subject to penalty.

I've already described what must be done.  There is no easier way (unless you are willing to pay several thousand dollars in otherwise unnecessary taxes and penalties).

Does a gain/loss calculation also need to be done for 2021 then, @dmertz?

If not, then is there any reason I couldn't simply withdraw the entire HSA balance as a regular distribution (rather than a return of contribution), and amend my 2021 return to pay the 6% on 475.01, amend the 2022 return to pay the 6% on 4,075.01 (the 2021 and 2022 contributions combined), and pay 20% on the distribution when I file for 2023?

If that is not a valid solution, then I have no idea how I can resolve this. My custodian just replied and said they can't give me the gain/loss calculations, since the HSA funds were transferred to a 3rd party broker (TD Ameritrade) for investing, and they have no insights into the activity in that account.

"Does a gain/loss calculation also need to be done for 2021 then?"

No.  I've edited my previous post to clarify that the gain/loss calculation must always be done for a return of contribution before the due date of the tax return, which is what you were asking about in regard to the 2023 excess contributions.  The corrective distribution for the 2021 excess is being done after the due date of the tax return and must be done as a regular taxable distribution of exactly $475.01 as I previously described.

Regular taxable distributions are subject to ordinary income tax, meaning that the money would be taxed twice since the original excess contribution was not excludible from income, and to a 20% extra tax since you are under age 65.  With a 2022 excess of $3,600 and a 2023 excess of $1,800, correcting these after the due dates of the tax returns would mean unnecessarily paying $324 in excess contribution penalties, $1,080 in early-distribution penalties and, say , $1,1188 in income tax if this falls in in the 22% tax bracket.

"they can't give me the gain/loss calculations, since the HSA funds were transferred to a 3rd party broker (TD Ameritrade) for investing, and they have no insights into the activity in that account."  That seems like a lame excuse, but it seems that it would be a waste of time to argue that.  My own HSA is similarly invested in a mutual fund, but the HSA custodian somehow always knows the daily value, so it has the information needed to do the gain/loss calculation (although I've ever had to ask them to do the calculation).

My guess is that you'll need to do your own research to determine the adjusted opening balance and adjusted closing balance for the gain/loss calculation described in CFR 1.408-11.  If information is unavailable, you'll probably need to make your best estimate.  The IRS is unlikely to question the calculation, particularly if the HSA custodian properly prepares Form 1099-R using the gain or loss value that you provide to them for the 2022 excess and the 2023 excess.

I really appreciate the clarification and your time @dmertz

I understand that the action of taking everything out as a regular distribution would mean I'd pay higher taxes unnecessarily. But it is honestly a relief to know this option exists. If I proceed with that route, I would consider it the same as buying "insurance" – in this case, insurance that I don't accidentally miscalculate my gains/losses and expose myself to IRS scrutiny. It's a high price to pay, but I'll know I can sleep at night. Plus, it would make completing the tax forms easier.

I will think about it and post a follow-up message on here once I make a decision in case anyone else in a similar situation finds this information helpful. Thanks again!

Properly doing a corrective distribution of the 2022 excess contribution after the due date of the 2022 tax return, including extensions, would mean taking a $3,600 (exactly) distribution after October 16, 2023.  Similarly, you would have to wait until late 2024 to take the $1,800 (exactly) distribution.

It would probably be unusual for the IRS to question the calculation of the gain/loss adjusted distribution, so it really doesn't make sense to me that you would pay several thousand dollars to avoid what would likely be a minor correction even if the IRS does challenge your gain/loss calculation, which is doubtful.

I appreciate the vote of confidence, @dmertz. The calculations seem daunting since, like you said, the account value fluctuates daily. Though, I was able to download the historic daily value of my TD account which is key for making these calculations. I contacted TD today to ask if they can tell me what time of day the account value reflects for any given day, and I also reached out to my HSA custodian to see if they can tell me what time of day my contributions were processed for the first contribution of each year. I know the dates, but it seems I need to also know the time to determine what the account value was "immediately before" the first contribution of the year, which is required for the calculation. (My investments were all in index ETFs and the account value sometimes fluctuates by more than $100 on any given day, so I want to ensure I'm not off by even one day.)

However, the other part that still makes the calculations seem daunting is your previous message where you said the calculation will depend on when the $475.01 is removed for 2021. I haven't looked into it enough yet to understand how/why/if this would affect the numbers I provide the IRS for 2022 or 2023. It was my original understanding that my custodian would remove all the contributions at the same time. However, do you know if the calculations would be more straightforward if I were to stagger the removals? For example, would it be better to remove the 2021 excess today, wait a week to remove the 2022 excess, and wait another week to remove the 2023 excess? Or would it not make a difference? Thank you.

I reviewed CFR 1.408-11 and it says that any distributions during the computation period need to be added back to the adjusted closing balance, so it turns out that it doesn't matter if you make the regular distribution of the $475.01 before or after the returns of the 2022 and 2023 contributions.  The adjusted closing balance will be the same either way.