I contributed to HSA for the year 2016 but , now 2018, I found out my HDHP is not eligible for HSA, What should I do now?.

[khoidtran]

 In January of 2017, I opened a private HSA account at a local credit union and contributed the maximum amount allowed  for the 2016 tax year, because I thought my HDHP was eligible for an HSA account. Now it's 2018 and I have not contributed any further amount to the HSA and now I just found out I was not eligible for the HSA. What should be my next step? What are my options? should I contact the credit union and convert the HSA account to something else? should I  amend my 2016 tax return to include the contribution as income?

[dmertz · Accepted solution]

Because only HSA-eligible individuals are permitted to open an HSA, if you were never an HSA-eligible individual, the account that you opened does not qualify as an HSA; no HSA exists.  (IRS Notice 2008-59 Q&A-23)  If this is your situation, the HSA administrator has a special procedure for dealing with this, so contact the HSA administrator and explain that you were never an HSA-eligible individual.

Because the account never qualified as an HSA and no HSA exists, the deposit did not constitute an HSA contribution.  Because the deposit did not qualify as an HSA contribution, you are not subject to any excess contribution penalties.  You must amend your 2016 tax return to remove the reported HSA contribution and include income the amount deposited, either by removing the deduction on Form 1040 line 25 or, if the contribution was through your employer and reported with code W in box 12 of your W-2, by including the amount deposited as miscellaneous income on Form 1040 line 21.

The special procedure followed by the HSA custodian will likely treat the account as a regular savings account.  If there has been any gain in investment value, you'll likely be subject to income tax on the gain.

[khoidtran]

Thank you for the answer and link to the publication, it helps.  However, my HSA custodian cannot change HSA account to other type and don't know protocol for reporting to IRS about this situation of error.  They would only provide withdrawal form and to mark reason for withdrawal.  List of reason has nothing about mistaken contribution or open account in error or anything related.  The only option that seems good is withdrawal of excess contribution after deadline, which will give report form 1099-SA with code 2.  Is this the right option to report to IRS by bank?  Thank you

[dmertz]

You can't do a return of excess contribution because the deadline for doing so with respect to an HSA contribution for 2016 was October 16, 2017, the extended due date of your 2016 tax return.  We are long past that deadline and anything reportable as a distribution from the account treated as an HSA would have to be reported as a regular distribution, code 1.  Treating this as an excess HSA contribution corrected by a regular taxable distribution would result in a 6% penalty and inclusion of the amount as income on your 2016 tax return, a 6% penalty for 2017, and, if distributed in 2018, a taxable distribution that is subject to an additional 20% penalty if you are under age 65.  If your income falls in, say, the 22% tax bracket, that would be roughly 44% in taxes and penalties on the amount that would be avoided by treating the account as not an HSA as described in IRS Notice 2008-59 Q&A-23.

You mentioned that the HSA custodian is a credit union.  I can only assume that either this is a small HSA custodian unfamiliar with this situation or you talked to a front-office person who is ill informed and you need to escalate to the back office personnel who know how to handle this properly.

In the absence of the HSA custodian handling this appropriately, you would have to take it up with the IRS.  You would need to convince the IRS that you were (and continue to be) ineligible to open an HSA and that the money that you received back was only taxable, not subject to penalty, and that any Form 1099-SA from the HSA custodian is erroneous.

[dmertz]

(Had you caught this prior to October 16, 2017, you could have corrected it with a return of excess contribution with no penalties or double taxation.  There would have been no need to go the not-an-HSA route to avoid penalties.)

[khoidtran]

Does this special procedure of handling of the HSA have a name or description that is describable so that I can tell them exactly what to do?  Or what form to file with IRS to let them know this? The person handling this talked to her administrator about it already and so I am guessing they are not familiar with this procedure.  

[dmertz]

The only phrase I've seen is a "return of a mistaken contribution" as you've already mentioned, which I've seen on several HSA custodian's forms.  The only authoritative reference I have is IRS Notice 2008-59.  Q&A-23 seems to be targeted at employers and states, "If the employee was never an eligible individual under § 223(c), then no HSA ever existed and the employer may correct the error."  Given the first part of that sentence, there's no reason to believe that an HSA exists no matter how the account was opened, based on IRS Notice 2004-2 Q&A-2 stating that those eligible to establish an HSA are those who are "eligible individuals" as defined in Q&A-2.  If no HSA exists because the individual was not an HSA-eligible individual, the money deposited can't be an excess contribution to an HSA and can't be subject to additional taxes.

It might just be that you have to take it up with the IRS as I indicated above.  If the IRS disagrees with my analysis, you'll end up owing the penalties and tax that I mentioned.  Regardless, you'll likely want to get the money out of the HSA before the end of 2018 to put an end to this situation.

One other possibility is that you could treat the HSA as actually existing and containing an excess contribution, then just spend all of the money on qualified medical expenses.  In the year that the balance in the account is reduced to zero the penalties will stop since the excess-contribution penalty for a given year is 6% of the lesser of the excess or the year-end balance.  The problem I see with this is that it's not clear that the excess contribution actually goes away, rather, only the penalty goes away as long as you never have an HSA balance at year end.

[Anonymous]

yes, you need to amend 2016 return by not taking the deduction and including form 5329 to pay the 6% excise tax 

you need to amend 2017 to pay the excise tax for that year because the excess remained.

you need to withdraw the money in the HSA before 12/31/18 to avoid the 6% tax for that year. even if you do. any income earned by the HSA must be included as other income on your 2018 return

Here's what IRS Publication 969 has to say about the excess contributions (contributions in excess of what is allowed):

Generally, you must pay a 6% excise tax on excess contributions. See Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts, to figure the excise tax. The excise tax applies to each tax year the excess contribution remains in the account.

Any excess contribution remaining at the end of a tax year is subject to the excise tax. See Form 5329.

You also must withdraw any income earned on the withdrawn contributions and include the earnings in “Other income” on your tax return for the year you withdraw the contributions and earnings.

[2985]

Hello-

I am having a similar issue but hopefully getting it cleared up all within the same year simplifying things a bit. I have a couple follow-up questions though. 

My situation is: I was told by my insurance provider that I was eligible this year to open a HSA. I've never had one before so I did as they suggested and was able to open one with Health Equity.  I contributed and used several thousand dollars this year on qualifying medical expenses (but never earned any interest), only to see when I went to renew my health insurance this year through the marketplace that only a rare few high deductible plans actually qualify and the one I had this year wasn't one of them!

I called my HSA provider as this post suggested and they said I need to fill out two forms to get it squared away. The two forms are: HSA Mistaken Distribution and HSA Excess Contribution.  I wanted to check here first if those seemed like the right forms to fill out and avoid any penalties which, according to this answer, I shouldn't have to pay any of since I was never eligible. I really don't want to get pegged with some 20% penalty for a mistake I did not know I was making!  I also don't know if I should close the account or not. My new health plan for 2022 Does qualify for a HSA but it kind of seems like I should start fresh with a new account. Thanks for any insights!

[Opus 17]

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@2985 wrote:

Hello-

I am having a similar issue but hopefully getting it cleared up all within the same year simplifying things a bit. I have a couple follow-up questions though. 

My situation is: I was told by my insurance provider that I was eligible this year to open a HSA. I've never had one before so I did as they suggested and was able to open one with Health Equity.  I contributed and used several thousand dollars this year on qualifying medical expenses (but never earned any interest), only to see when I went to renew my health insurance this year through the marketplace that only a rare few high deductible plans actually qualify and the one I had this year wasn't one of them!

I called my HSA provider as this post suggested and they said I need to fill out two forms to get it squared away. The two forms are: HSA Mistaken Distribution and HSA Excess Contribution.  I wanted to check here first if those seemed like the right forms to fill out and avoid any penalties which, according to this answer, I shouldn't have to pay any of since I was never eligible. I really don't want to get pegged with some 20% penalty for a mistake I did not know I was making!  I also don't know if I should close the account or not. My new health plan for 2022 Does qualify for a HSA but it kind of seems like I should start fresh with a new account. Thanks for any insights!

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The penalty for making unqualified withdrawals (not used for medical expenses) is 20%, but that does not seem to apply here.  The penalty for making ineligible contributions is that you don't get the tax deduction, plus 6%.  The 6% penalty is on the amount of ineligible contributions or the amount remaining in the account, whichever is smaller.

So one option would be use the "return of excess contribution" form to request the remaining balance from your account.  You don't need to request all the contributions, only the remaining account balance.  You only need to do this by the filing deadline (April 15, 2022), so you could leave the account open, start making contributions for 2022, and then withdraw the excess from 2021.  (Or you could request the return of excess now, close the account, and open a new account.  It depends on whether there are account closing or opening fees or other maintenance fees and whether you are happy with the bank or want to change banks.). In Turbotax, you will first report the contributions.  Then when you indicate you did not have qualifying insurance, the contributions will be added back to your taxable income (not deducted) and the penalty will be calculated on the remaining balance (zero), so zero penalty.  With a return of excess, the bank must also return the earnings on the ineligible contributions, which is probably only a few cents interest, unless you invested in securities that performed better.  That interest would be taxable on your 2021 income (if the return is processed before 12/31) or 2022 income (if you do the return after 1/3/22.)

Note that it may take a few days to process, and there are only a few business days left in 2021, so you might not get the return processed in 2021 even if you request it right away.

Your second option would be to leave the ineligible balance in the account, pay the penalty and then contribute less next year.  For example, suppose your remaining balance is $500.  If you leave it alone, you would pay a 6% penalty ($30), and then for 2022, if you have a single plan and are eligible to contribute $3650, you would contribute no more than $3150, and the $500 excess from 2021 would be counted as a legal 2022 contribution so there would be no more penalties.  

If you have additional medical expenses that have not been reimbursed yet, a third option would be to request reimbursement before the end of the year and zero out your balance that way.  

You would only use "Mistaken distribution" if you wanted to put money back in the account because you withdrew if for a non-qualified expense.   As long as your reimbursements were for qualified medical expenses, you don't need this form, even if the original source of the money was ineligible contributions.

[J81]

Your HSA custodian cannot convert a health savings account into a traditional savings account. This is not a thing. So long as the account has funds in it, a yearly tax form will generate showing the value, plus any contributions made for the corresponding tax year of the form. 
The fix depends on whether it is corrected within the deadline of the tax year the contribution was made, or if that time has passed. 

Within deadline: If your employer sponsors the account and contributes pre-tax out of payroll, hit them up first. Your custodian can provide them a form to return the funds back to payroll to be taxed.  Most employers will not bother with the hassle, but I see many do it each year and the worst thing that can happen is being told no. If they are not willing to do this, you will need to do a Return of Excess Contribution form. 

Outside of deadline:  Anything outside of the deadline for the corresponding tax year will have to be corrected by a Mistaken Contribution form. If there are more than one tax year involved, I suggest doing a separate form for each tax year, even if the custodian’s form allows for more than one tax year on the same form. I won’t deep dive into why the extra hassle is worth it, but I’ll sum it up by saying it involves a higher potential for human error that can take things from level nuisance to outright maddening. 

 How corrections are reported: This ultimately depends on the method of correction. 
Employer: If corrected within deadline and before original Form W2’s are sent, no reporting necessary. They will simply put the correct info on your Form W2. (Most unlikely scenario, unfortunately.) If corrected within deadline, but after original W2’s have been sent, they will need to do a corrected Form W2, in addition to the correction with the custodian.

Return of Excess Contribution Form: This will generate two Form 5498’s, the original and the corrected. 
Mistaken Contribution Form: This  will generate a corrected form for each tax year applicable.

Callouts: 

• Corrected Form 5498 will look almost exactly like the original. Look closely for the checked “Corrected” box. 
• Adjust your expectations, this is a hassle no matter how you go about it.
• Expect the possibility of having to do the same form twice. (Depending on the form.) Round 1 informs the amount and the tax year to the custodian. Round 2 includes any applicable interest that cannot be calculated without the information from round 1, resulting in a slightly different (but correct and official) dollar amount. Since your John Hancock is required to both inform the custodian, and for your custodian to make it official, just go in with the expectation that you might be told to repeat the same form with the new dollar amount from calculated interest.
• If you spent the funds that should have never been contributed in the first place, pull up your drawers and take a deep breath—you just leveled up to more forms, time, hassle, and parting with money for some time. You will need to do a Mistaken Distribution form and repay your HSA before the correction process  can even begin. There is no way around it.
•  Lastly, it’s important to know that HSA’s are owned by you and regulated by the government. Your employer, broker, or even your HSA custodian hold no legal responsibility for any consequences resulting from money moving in or out of the account in a way that violates regulation. HSA’s are the only triple tax advantaged accounts that exist. Their long-term benefits and flexibility of use put a 401k to shame and send FSA’s hiding under their blankets of custodian-required receipts—but they are still governed by the IRS and should be opened and used only after one does their homework. 

I hope this helps!