Should I just zero out my HSA balance?

[LabyrinthMike]

Unfortunately for 2022, I signed up an HSA, even though I was 65 and had enrolled in Medicare A the previous year. (This restriction was not at all made clear during my company's open enrollment process.)  So, I have been contributing to the HSA for the entire year of 2022, even though I was 66 for most of it. I have not renewed the HSA for next year, but for 2022, is the best plan to just go ahead zero out the HSA account? A separate debit card for health related expenses was sure nice, but something that I live without.  On the other hand, if I'm going to pay a penalty either way, I could just leave the money already in the HSA and just spend it down.

I've tried reading the rules on this, but it quickly turns into "blab, blab, you're screwed, blab, blab", so a Yes or No answer would be appreciated.  If you can't give me that, please point me to a definitive source of information.

[Opus 17]

The penalty for making HSA contributions when you are ineligible is that you pay the income tax (the contribution is not tax deductible) plus a 6% penalty for every year the ineligible balance remains in the account until you spend it.  

"A separate debit card for health related expenses was sure nice". Why?  It's your money either way.  If it was tax-free money, sure.  But you don't get the tax deduction and you pay a penalty.

Yes, you need to remove the ineligible contributions.  This is a special procedure and not the same as a regular withdrawal.  If you earned any money on the ineligible contributions while they were in the account, those earnings are subject to regular income tax. 

[LabyrinthMike]

<<Why?  It's your money either way.  If it was tax-free money, sure.  But you don't get the tax deduction and you pay a penalty.>>

It was just a way to have a pay an expected expense without a separate step of transferring the cash out of savings. I'm not sure why you even asked this question. Are you just trying to make me feel worse about this situation?

<<Yes, you need to remove the ineligible contributions.  This is a special procedure and not the same as a regular withdrawal.>>

OK. I guess I'll see if I can find that procedure.

[Opus 17]

@LabyrinthMike 

The idea behind the HSA is that you deposit money tax free. That creates a special tax free account that you can withdraw for expenses.

Since you can’t use the tax-free account because your deposit is not tax deductible, you could create your own savings account for medical purposes by depositing money onto any prepaid  debit card you like.  You have to be careful of the fees, but some of them have rewards.

Because you are ineligible for tax free contributions to an HSA, using the HSA as a medical debit card would mean voluntarily paying a 6% tax to the government that you wouldn’t have to pay if you pay your medical expenses in any other manner.

[TomD8]

@LabyrinthMike --

"Should I just zero out my HSA balance?"

No, you don't have to "zero out" your HSA account after you enroll in Medicare.  You can still use your existing HSA funds to pay qualified medical expenses.  In fact, once you reach age 65 you can use your HSA funds to pay the premiums for Medicare Parts A, B and D and Medicare Advantage plans (but not for Medicare supplemental insurance such as Medigap).

What you can't do once you enroll in Medicare is contribute new funds to your HSA.  If you do, those will be considered "excess contributions."

Excess contributions aren’t deductible. Excess contributions made by your employer are included in your W-2 gross income. If the excess contribution isn’t included in box 1 of Form W-2, you must report the excess as “Other income” on your tax return.  Generally, you must pay a 6% excise tax on excess contributions.

You may withdraw some or all of the excess contributions and avoid paying the excise tax on the amount withdrawn if you meet the following conditions:

• You withdraw the excess contributions by the due date, including extensions, of your tax return for the year the contributions were made.

• You 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.

[LabyrinthMike]

I guess the point behind my question was to determine the proper procedure to shutdown this HSA account and what to do with the balance in it. (I only mentioned the debit card because it was the most useful thing in the HSA, not because I was trying to keep it. Unfortunately that comment turned out to be a distraction.)

As best as I can tell, the ineligible contributions procedure is when the HSA is a valid one and you have contributed too much. Apparently you have to contact the company managing the HSA (the custodian) and request to have the excess funds transferred out, so it will not look like a transaction and have to follow the rules for what is allowed.

Looking at publication 969, there are clear instructions about what to do with excess contributions: Excess contributions. You will have excess contributions if the contributions to your HSA for the year are greater than the limits discussed earlier. Excess contributions aren’t deductible. Excess contributions made by your employer are included in your gross income. If the excess contribution isn’t included in box 1 of Form W-2,
you must report the excess as “Other income” on your tax return.

So, the answer to my original question is "Yes", the money should be removed. The next question is how is the best way to do that. Talking with the Custodian, they have a procedure for transferring the balance to a new custodial account, but not what to do about excess contributions. Since the entire thing is excess, really nothing is subject to the Qualified Expenses rules. Looking at 969 again, we have: You may withdraw some or all of the excess contributions and avoid paying the excise tax on the amount withdrawn if you meet the following conditions.

I believe that I meet those conditions. It's tempting to just transfer the balance to my bank account, but I'm going to verify that.