Mistaken HSA excess contribution withdrawal: mischaracterized 1099-SA form

[achen2309]

Hello,

In 2021, my employer contributed the max amount pre-tax ($3600) to my HSA. I was eligible through December 2021, so the last-month rule was applied.

However, in January 2022 I lost HDHP coverage and failed the "testing period", which stated that "For the last-month rule, the testing period begins with the last month of your tax year and ends on the last day of the 12th month following that month (for example, December 1, 2021, through December 31, 2022)." 

What should have happened was - just waited to report this information in 2023 in my 2022 Tax return and have the extra amount that failed the last month rule's testing period to remain in the HSA but be taxed as income. According to IRS instructions: "If you fail to remain an eligible individual during the testing period, for reasons other than death or becoming disabled, you will have to include in income the total contributions made to your HSA that wouldn’t have been made except for the last-month rule. You include this amount in your income in the year in which you fail to be an eligible individual. This amount is also subject to a 10% additional tax. The income and additional tax are calculated on Form 8889, Part III."

HOWEVER, in 2022, I did not know about the "testing period" and mistakenly though that I had to manually withdraw the excess money as I hadn't been HSA eligible for all the 2021. I filled out the "return of excess" form with my brokerage to withdraw the money from my HSA, and the money was deposited in my bank account. This year, I received 1099-SA form with distribution code '2' , which still labels it as 'excess contributions' and not taxable. I believe this money is taxable, so what should I do with this incorrect 1099-SA saying I withdrew "excess contributions" that weren't actually excess and should be taxed as a normal HSA distribution?

Thank you!

[BillM223 · Accepted solution]

"Failure to maintain HDHP coverage" is not the same as "excess contributions" as I think you now understand. And to clarify, "as I hadn't been HSA eligible for all the 2021", you were eligible to contribute for all of 2021, until you failed to maintain the HDHP coverage in 2022. 

You should go through the TurboTax HSA interview. At some point, TurboTax will realize that you failed to maintain your HDHP coverage (it will say something about a "lapse in coverage"). Then you will be taken through a number of questions to determine what your annual HSA contribution for 2021 would have been if it had not been for the last month rule (which may sound the same as the calculation for excess contributions, but it's not).

As a result of the failure to maintain HDHP coverage, the amount that would have been "excess" in 2021 is added back to your income in 2022. NOTE, the excess for 2021 is 3,600*11/12, or 3,300, because you did have HDHP coverage for one month (December). Then you will be assessed a 10% penalty on that of that.

The preceding is without regard to the 1099-SA that you received.

What you might do in terms of that 1099-SA is to contact your HSA custodian, and ask them to recharacterize the withdrawal of excess contributions as a mistaken contribution. They probably won't do it because it's been too long since you did the original withdrawal, but you need to give them a chance to do it. If by some miracle they agree, you will have to complete a form and send them a check for the amount of the excess that they sent you.

The real problem is that you withdrew dollars from the HSA for reasons other than for medical expenses. Unlike you can get the HSA custodian to reverse this, when you enter the 1099-SA into TurboTax, you will 

need to do two things:

1. change the distribution code from '2' to '1', and

2. have to answer that this distribution was not for medical expenses. 

Then, this amount will be added to income (in addition to the amount above) and penalized 20% in addition. And unless the HSA custodian reverses the earlier withdrawal, you will need to enter the 1099-SA because the IRS now has a copy of it and will wonder why you did not enter it on your return.

Is there anything else you can do? Well, you can do this: do you have any medical bills from the last year (i.e., 2022) that have not been paid yet? If so, then collect these bills, and make a list, showing that they were paid by this withdrawal, and stick in your tax files. This may or may not pass an audit, but at least you can show that you tried to correct the situation. 

You must document everything you did (like changing the '2' to '1') and why, because what you did will no longer match the paperwork of your HSA custodian.

[achen2309]

Thanks so much for your explanation!

I have filed for an extension. I've called my HSA custodian and they are unable to change the distribution code on my 1099-SA from a '2' to a '1'. 

This is what I think I will do:

I can change the 1099-SA on my end to say distribution code '1' (Normal distribution), and have the amount taxed and penalized as it should be. I might risk getting audited because my 1099-SA does not match the HSA custodian's, but if I am doing what I think is the right thing and paying my taxes and penalties, it should be fine, correct?

I can mail my tax return with a note explaining all of this. Does a handwritten and signed note work fine? Otherwise, how do you recommend documenting this?

Thank you in advance.

[BillM223]

I think if you have documented on paper everything that you did and why and saved it in your tax files, that you should go ahead and try to e-file. The IRS doesn't really want explanations on paper on a paper return, unless they specifically ask for it (they do sometimes, but not here).

Yes, changing the 1099-SA may trigger an audit, but it's unlikely in these days of a weakened IRS (the $80 billion has not yet made a real effect). And you are right that you did whatever you could to make your return correct and paid all taxes and penalties, so perhaps you would even join the small but not insignificant number of taxpayers who actually are issued refunds after an audit.

So document what has happened and why, and if you ever get a letter about this, you will be prepared.

[achen2309]

I updated my distribution code to 1- normal distribution and indicated I did not use it for medical expenses. My return was accepted today. Thank you for your help!