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

[MrHarriet]

@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.)

[dmertz]

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.

[MrHarriet]

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.

[dmertz]

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).

[MrHarriet]

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.

[dmertz]

"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.

[MrHarriet]

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!

[dmertz]

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.

[MrHarriet]

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.

[dmertz]

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.

[MrHarriet]

Ok, I was able to calculate the gain/loss for the account for 2022 and 2023 @dmertz 

It actually worked out well because the first contributions of each year hit my HSA on a Saturday, so clearly after the market closed. The net earnings were -$75.50 for 2022 (a loss) and $125.60 for 2023 (a gain). This makes more sense to me, given the performance of the stock market.

A question I still have is related to the loss-adjusted amount you refereed to earlier. On the instructions for Form 8889, it only makes this reference: "You also withdraw any income earned on the withdrawn contributions and include the earnings in Other income". And on the instructions for Form 5329, it says to "withdraw any income earned on the withdrawn contributions" but does not say I can add adjust for losses. Should I assume I need to add the income for 2023, but I can't adjust for the losses in 2022? Ultimately the HSA custodian is asking me for the amount I am requesting to be withdrawn (the excess contributions) as well as the income earned for both years. So my current interpretation is that I would be asking them to remove $3,600 for 2022 and report $0 income earned, and then asking them to remove $1,925.60 for 2023 and report $125.60 income earned. Do you know if this interpretation is correct?

Another small piece of ambiguity is on Form 8889, it refers to Excess Contributions You Make "including contributions made on your behalf" and Excess Employer Contributions. These don't seem mutually exclusive. All of my contributions were made through my employer via payroll. So for example, in 2022, I contributed $3,000 and they contributed $600 – on my behalf.  On the tax forms they provide, this is all lumped together as a single value. Even on my pay stubs it only show as $150 per paycheck, not $125 from me and $25 from them. Do you happen to know where this is supposed to be entered? Thanks!

[dmertz]

IRS Notice 2004-50 Q&A 34 says to compute the adjusted distribution using CFR 1.408-11.  This implies that the adjustment is to be made for both gains and losses.  Only gains are taxable.  In your case the return of the excess contribution for 2022 of $3,600 will mean a distribution of $3,524.50, with the Form 1099-SA having $3,524.50 in box 1, $0 in box 2 and distribution code 2 in box 3.  The Form 1099-SA for the return of the 2023 contribution will have $1,925.60 in box 1, $125.60 in box 2 and code 2 in box 3.

All contributions are your contributions in that they go against your contribution limit, even those made by your employer.

[MrHarriet]

Thank you so much, @dmertz. I feel ready to ask my HSA custodian to make the removals accordingly. Do you know if the tax forms 1099-SA that they will send to me will all be for tax year 2023?

[dmertz]

Yes, these will be 2023 Forms 1099-SA that you will receive by about the end of January 2024.  (There is a chance that the HSA custodian will report the combined totals for the return of the 2022 and 2023 returns of contribution on  single Form 1099-SA because they have the same distribution code.  The Form 1099-SA for the regular distribution of $475.01 will be on a separate Form 1099-SA with code 1.

[MrHarriet]

Hi @dmertz, I'm running into some issues with the HSA custodian. It's not clear they understand how the IRS forms should be filled out, and they have cast a shadow of doubt. They suggested I may need to withdraw the entire $3,600 for 2022 (rather than the $3,524.50) but everything I have read says I should factor the loss into the distribution. So that's one question.

But the main question is, if they combine the 2022 and 2023 distributions on a single form, should box 2 still show the $125.60 gain (from 2023)? Or should it show combined net gain/loss for both years, which would show a gain of $50.10? Box 1 would show the same value of $5450.10 either way.

(Note: I had to update these numbers by a few cents because a little bit of interest trickled into the account after my previous reply, but am still referring to the original values in this reply to avoid confusion.)