HSA combined with Spouse HRA/FSA

[Frozo40]

I’ve got a two prong question:

1: I’ve had a single coverage HDHP and HSA since 2012 and have always contributed to it. Got married in 2015 and my spouse and I had a child in September of 2016. My spouse has separate insurance from different employee and Spouse switched to self plus one CDHP when we had our child in September 2016. The CDHP plan automatically gave Spouse a $1,000 general purpose HRA, which was mainly used for spouse and child during the years. Have I been ineligible for HSA since that point? What do I do now?

2: For calendar year 2020 coverage, spouse added a $1,200 FSA and coverage begins in January of every year. Spouse used all $1,200 in March 2020 on child. Have I been ineligible for HSA all year? What do I do now? 

[Anonymous]

Standard Health Care Flexible Spending Accounts (HCFSAs) which may reimburse medical expenses are disqualifying coverage for both an individual as well as their spouse for purposes of the tax benefits of a health savings account (HSA). Employees wishing to open and contribute to an HSA (or have employer contributions into their HSA) would not be eligible if their spouse has a HCFSA (unless the FSA is a limited purpose HCFSA with reimbursements restricted to dental and vision expenses).

withdraw your 2020 contributions from the HSA + any earnings thereon before 12/31/2020.   any earnings are taxable.

if your spouse has an FSA or an HRA with medical expense reimbursement through their employer, you are disqualified from participating in an HSA.  

however, there are certain HRA's that don't prevent contributions to your HSA

2016 is a closed year so you should file amended returns for 2017-2019 showing excess HSA contributions.  since so many years are involved consult a tax pro.  

Case Study:
ABC Company offers benefits on a calendar year basis. Effective January 1, 2020, they will begin offering an HSA qualified HDHP and will make HSA contributions to those who are eligible and establish an HSA. Employee John is interested in the HSA, his wife Mary is also employed. Her employer’s plan also runs on a calendar year basis. Mary is currently enrolled in a standard health care FSA through her employer.

Can John begin contributing to the new HSA offered by his employer on January 1st?
NO! Because he is eligible to receive health care benefits under Mary’s FSA, John cannot contribute (or receive employer contributions) to an HSA until he is no longer covered by a standard HCFSA.
What if John and Mary exhaust Mary’s FSA balance prior to December 31st?
Unfortunately this still does not permit John to contribute to an HSA. The coverage under the FSA applies to the entire plan year in which you had coverage, not just the duration of when funds are available.
Can Mary terminate her FSA as of November 1st?
Unfortunately no. The open enrollment of one spouse does not allow for the other spouse to change their FSA benefit mid-year. This is not a permitted election change event.
Can Mary convert her standard HCFSA to a limited purpose HCFSA as of November 1st?
The regulations are very unclear and additional guidance from the IRS would be appreciated. Based on the change of election rules, there is nothing that expressly permits this at the participant level. Please check with your administrator for their interpretation of the regulations.
What is the earliest John can begin contributing to an HSA?
The earliest John would be eligible to contribute to an HSA (assuming he meets all other requirements to be HSA eligible and has no other disqualifying coverage) would be January 1, 2021. However, Mary’s can't have an FSA as of 1/1/2021

[Frozo40]

For the year 2020, would the last month rule apply considering that the HRA and FSA funds were depleted in March, all on our child’s medical bills?

[Opus 17]

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@Frozo40 wrote:

For the year 2020, would the last month rule apply considering that the HRA and FSA funds were depleted in March, all on our child’s medical bills?

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No.  You are still "covered" by the FSA.

The FSA is definitely disqualifying because it can be used to pay for care for the owner, their spouse and their children.  The only way not to be covered by the FSA is for your spouse to quit with the account empty.

In the future, your spouse may be interested in a "limited purpose" FSA.  This covers care items not normally covered by insurance (like eyeglasses and braces) and is not disqualifying for your HSA contributions.

The HRA is disqualifying if your spouse was allowed to spend funds for your care.  If it was restricted to her care only or her care plus her children, then it will not be disqualifying.

@dmertz is the best person to run you through the steps of correcting this.

[dmertz]

Excess contributions for 2020 can be corrected by obtaining a return of excess contribution.  The HSA custodian will calculate the investment gain or loss attributable to the contribution being returned and distribute the adjusted amount to effect the return of the amount of contribution requested to be returned.  Any attributable gains distributed will be taxable as ordinary income on the tax return for the year in which this distribution is made.

The excess contributions for years prior to 2020 can only be resolved by making regular, taxable distributions of the excess amounts.  Regular taxable distributions (those not reported as used for qualified medical expenses) are also subject to an early-distribution penalty (additional tax) of 20% if the distribution is made before you have reached age 65.  This makes the excess contributions you made for years prior to 2020 extremely expensive since they will not have been excludible from income on the tax returns for the year for which the contributions were made, are subject to 6% excess contribution penalties each year that they were in the account (including the year for which the excess contribution was made), the money taxable again when the excess is corrected by a regular taxable distribution and potentially subject to the 20% additional tax.  For example, if you are under age 65 (which seems likely since you had a child in 2015) and made an excess contribution of $3,350 for 2015, that excess contribution will have accumulated 30% in excess contribution penalties, and the corrective distribution in 2020 will be subject to a 20% additional tax and ordinary income tax.  If your marginal tax rate is 22%, that means that 72% of that contribution will be lost to income taxes and penalties and will also have not reduced your 2015 taxable income.  Excess contributions for later years will have accumulated a smaller percentage in excess contribution penalties but will still incur the same income tax and 20% additional tax upon correction.  (I'm assuming that the year-end balance in your HSA each year was greater than the sum of your excess contributions; the excess contribution penalties are 6% of the lesser of the amount of excess contributions or the year-end balance.)

The only other thing you could potentially do is spend the HSA down to zero on qualified medical expenses before the end of the year.  With a zero balance in your HSA you would have no 20% penalty but you would still retain the excess contribution total to come back to bite you if you ever made another HSA contribution that brought your year-end balance above zero.

[Frozo40]

Wow, thanks for all the detailed response. This sounds unbelievable overwhelming and complicated. It’s a shame that the IRS has complicated something like this. I’m definitely at a loss at where to begin. It also sounds like a ton of money I do not have. The majority of the HSA has always been spent on my child’s medical care. Crazy.

[Anonymous]

agree that the HSA rules are overly complicated but don't blame the IRS. It's Congress that enacted the laws and the POTUS that signed them into law that are to blame.  How would you like to be in a position to write the details explaining what hundreds of people who you can't consult with thought they were writing as a new tax law?  

[dmertz]

If most of the money in the HSA was been spent each year, excess contribution penalties will be correspondingly small, based on year-end balances, and there will be little that might remain to distribute as a regular distribution subject to tax and penalty or to be spent down before year-end.

[Opus 17 · Accepted solution]

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@Frozo40 wrote:

Wow, thanks for all the detailed response. This sounds unbelievable overwhelming and complicated. It’s a shame that the IRS has complicated something like this. I’m definitely at a loss at where to begin. It also sounds like a ton of money I do not have. The majority of the HSA has always been spent on my child’s medical care. Crazy.

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As I understand it, here's what you need to do.

For 2020, stop making new contributions, and withdraw any remaining money as a "return of mistaken contributions".  This will probably require you send the bank a a signed form of some kind.  You want to end the year with zero balance.  The penalty for all your past mistakes would be based on your account balance, so if it is zero, there is actually no penalty to pay.  

Then going forward, if you ever become eligible to make HSA contributions again, you have a large penalty "accumulated" from the past.  You can avoid paying this if, for every year that you contribute to your HSA, you spend it all down to zero at the end of the year.  You would get the benefit of paying expenses tax-free but you lose the benefit of accumulating the excess in your account long-term, which can really add up (it becomes effectively like a "super IRA" if you can fully fund the account and don't have to spend it.)

Depending on your age and other situations, you might want to clear that penalty so that you can accumulate savings in the HSA for your long term future.  Here I see two possibilities.  

1. Pay the penalty off.  According to Dmertz, this is done by withdrawing the excess at the end of every year and paying income tax and a penalty on it until you have used up the penalty balance.  Then you could accumulate future funds tax and penalty-free.

2. You might be able to sit tight until the statute of limitations expires, this is 3 or 6 years, depending on the size of the error.  If you sit on your hands until the statute of limitation expires (April 15, 2023 or 2026 for a 2019 return) then maybe you can pretend the mistake never happened and contribute to a new HSA at that time without fear.

I would not undertake either of these two steps without competent professional advice.  But, suppose you are 35 years old, your single HSA contribution limit is $3500 (plus inflation adjustments) and your medical expenses are $2000 per year.  If you cleared the penalty so that you could allow your HSA funds to accumulate, and if you invested them in a conservative mutual fund instead of whatever pitiful interest rate the cash account pays, you could have over $100,000 by age 65, that you could withdraw tax-free for medical expenses or withdraw and pay income tax like an IRA but with no penalty.  It may be to your long term advantage to have a professional figure out the best way to clear the penalty so you can use the substantial benefits of an HSA going forward. 

[Frozo40]

Thanks again for all the great answers. I think I at least have an understanding now of where to begin and am equipped with enough information to approach a professional and judge whether they know what they are talking about. I wish Congress would not have created all these complications and conflicting laws. It is an honest mistake on our part and our employers allowed us to do it and we were never counseled on it by anyone, even when we filed taxes every year. Just crazy.