Avoid HSA Tax for Non-Coverage

[johnrlewis1273]

When completing my taxes this year on TurboTax Desktop, I discovered that some of my HSA contributions  in 2021 were subject to tax and a 10% penalty because I did not have HDHP coverage for all of 2021.  I had an HDHP plan for 10 months, so the amount that I was allowed to contributed was reduced.  My wife had an HDHP with an HSA for the entire year.  TurboTax calculated the amounts allocated to each of us on our 8889 forms.

So, I believe I am stuck with this situation and will have to pay for the excess contribution in 2021.

My question, though, is related to the 2022 tax year.  Once again, I was without an HDHP plan for 4 months, and I believe I will end up in the same position when I do my taxes next year.  And, it will likely be worse since I didn't have coverage for 4 months instead of 2. 

Is there any way I can fix this situation now before I file my 2022 tax return?  I tried to manipulate some of the numbers in TurboTax to see what might happen if I remove 'excess' contributions, but I didn't feel comfortable with the results.

Thank you!

[BillM223]

Please do not remove excess HSA contributions until TurboTax tells you the amount to remove - the reason is that taxpayers frequently miscalculate the amount that is in excess and removing amounts that were not in excess can cause more tax.

Since you referred to a 10% tax, I assume that this came from lines 18 through 21 on your 8889 (not your spouse's). Since I believe you were hit with a 10% tax because of a "failure to maintain HDHP coverage", let me explain how this works so that you can apply it to your situation (I don't have enough information about to know how it fully applies in your case).

When you do not have HDHP coverage for the entire year, but do have HDHP coverage on December 1st, then you are able to use the "last-month rule". This rule allows you to use the full annual HSA contribution limit, no matter how few months you had coverage. 

The "catch" is that you must keep HDHP coverage for the next year, or the previous year is recalculated as if you did not have the higher limit, and you pay 10% tax in addition.

So, my assumption is that you started your HDHP coverage in 2021 after January 1st, but was covered on December 1st - this triggered the last-month rule. However, since you did not have HDHP coverage for all of 2022, the additional tax and penalty processing for lines18 through 21 was triggered.

For 2022 to 2023 (your final question), the last-month rule would be triggered again only if you did not have HDHP coverage for all 12 months (as you evidently did not), but also if you did have HDHP coverage on December 1st  for 2022 (I can't tell if you did or not).

Let us know which months you had HDHP coverage for 2022.

[johnrlewis1273]

Thank you for your response.

You are correct - I am referring to lines 18-21 on my 8889 form.

I had HDHP coverage in 2021 for the months March-December.  For 2022, I had HDHP coverage January-March and August-December.  At this time, I anticipate I will have HDHP coverage for all of 2023.

So, based on your reply, if I have coverage for all of 2023, the last month rule will not be triggered and I shouldn't be subject to the additional 10% tax - is that correct? 

[BillM223 · Accepted solution]

Actually, based on what you entered for 2022 above, the last-month rule will be triggered for December 2022 (that is, TurboTax will calculate your annual HSA contribution limit based on the maximum amount, not pro-rated by the number of month you were covered). However, it may not make any difference, if you maintain HDHP coverage, as you say you will in 2023.

You will not be affected by any penalty for the last-month rule, until the following year. Thus as you do your 2022 return, you are being referred back to 2021 (because you did not have HDHP coverage for each month in 2022), and on your 2023 return, you will be referred back to 2022 if you don't have HDHP for each month in 2023.

However, when you do your 2023 return, you should not see this last-month rule interview because you had HDHP coverage (at least you expect to) all year.

[Opus 17]

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@johnrlewis1273 wrote:

Thank you for your response.

You are correct - I am referring to lines 18-21 on my 8889 form.

I had HDHP coverage in 2021 for the months March-December.  For 2022, I had HDHP coverage January-March and August-December.  At this time, I anticipate I will have HDHP coverage for all of 2023.

So, based on your reply, if I have coverage for all of 2023, the last month rule will not be triggered and I shouldn't be subject to the additional 10% tax - is that correct? 

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There are two different kinds of HSA penalties.  If you make excess contributions in general, there is a 6% ongoing penalty unless you remove the excess funds.  However, if your contributions are considered excess because you fail the testing period for the last month rule, you pay a one-time 10% penalty, and not the ongoing 6% penalty. There is no need to remove any funds.

On your 2021 tax return, if you had HDHP coverage in December, you could make a full year contribution.  Because you failed the testing period in 2022, some of the 2021 contribution is added back to your taxable income on your 2022 return and is subject to a 10% penalty.  But that's a one time penalty.

Then, because you had an HDHP in December 2022, you can again use the last-month rule to make a full contribution for 2022.  As long as you main coverage for all of 2023, you would not pay a new penalty on your 2023 tax return.  

[Opus 17]

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@johnrlewis1273 wrote:

So, based on your reply, if I have coverage for all of 2023, the last month rule will not be triggered and I shouldn't be subject to the additional 10% tax - is that correct? 

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There's a slight language quibble.  You can use the last month rule to make a full year contribution if you were covered in December, even if you missed some coverage earlier in the year.   The penalty is triggered if you fail the testing period in the following year. 

[johnrlewis1273]

I have a follow-up question related to the last-month rule.  How will it work if I contribute to my HSA and am employed through the end of 2023, then decide to retire at the end of the year?  Will all of my contributions in 2023 be subject to income tax and the 10% penalty in 2024, since I will not have an HDHP in 2024 (assuming I do not buy HDHP insurance)?  Or, what if I retire before December - any issue with those HSA contributions being taxable?

[Opus 17]

@johnrlewis1273 

The last month rule exists so that a taxpayer can make a full year limit contribution even if they were not eligible for the full year, by relying on their eligibility in the following year. If you are eligible for all of 2023 because you have qualifying coverage, then you are eligible, and there is no reason to refer to the last month rule. 

[BillM223]

No.

The 10% penalty for failure to maintain HDHP coverage is invoked ONLY when you use the last-month rule in the previous year. If you had HDHP coverage for each of the months in the previous year, then there is no need for the last-month rule, thus, no need for Failure to Maintain HDHP Coverage penalty.

However, what do you mean by "retire"? If you mean, go on Medicare, it is normal for the Social Security Administration to back date your coverage for up to 6 months. Depending on your circumstances, this could mean up to 6 months of 2023, that you would not be eligible to contribute to your HSA.

So tell us what "retire" means and we will let you know how it affects you.

[johnrlewis1273]

I think my question was answered.  It was a hypothetical question to try to understand the implications of the last-month rule.  What I meant by 'retire' was to retire from working, where I may not have access to an HDHP medical plan.

Thanks!