Pay Back HSA or not?

[dadgad5651]

In 2017 took itemized $866 medical deduction based on $14,000 in medical expenses. High AGI so only $866 deduction based on 7.5% over AGI. 

In 2018 I withdrew $2K from HSA not knowing once I itemize those deductions on a previous return, I cannot withdrawal same money in later years, without paying tax and penalty. Do I return the 2K to my HSA to avoid tax/penalty, or not, because my 2017 medical deduction was only $866, while my actual expenses were 14K ($5400 of which were non-premium qualified expenses)?

[Opus 17 · Accepted solution]

Firstly, you can only use money from an HSA to pay for expenses that were incurred after the HSA was opened.  As long as the HSA was opened before the $14K bill (even if it was empty) then you are ok.

Second, don't try and return the HSA money.  Instead, report the $866 as a taxable recovery (reimbursement of a previous deduction).  Even though you deducted $14K, your tax benefit was only a $866 deduction because of the 7.5% rule.  If you get tax-free HSA money to pay the expenses that is more than $866, that would mean you can't have the tax benefit of the deduction any more.  So report the HSA as usual (not taxable) and then report the $866 as a taxable recovery.  It is included in the very bottom item on the wages and income page under "other uncommon income."

[dadgad5651]

Thanks guys. What a grey area this is. How does the IRS keep track: In one tax year, someone itemized medical expenses and received some benefit, then, 5 or 10 years later, that person withdrawals from their HSA,,,,,,any amount to pay qualified expenses, who is to say it's tax free or not? Surely on review the IRS can go back each year to see the total amount of itemized medical deductions, and compare against the current HSA withdrawal to make sure only the amount above the total of all the itemized medical deductions (actually received based on AGI rule). The form 8889 doesn't ask whether any of your HSA withdrawal money was previously itemized as a deduction.

If I have to give back my $866 deduction (and keep the 2K withdrawal), it might easier to do nothing, because I know for the rest of 2018 I will have expenses that I will pay out of pocket, and those expenses will offset the 2K in withdrawals. I don't know if I need to offset 2K, or just $866, in 2018.

[Opus 17]

If you have at least $866 of medical expenses in 2018, and don't make further withdrawals, then that will take care of the issue.

Also, I didn't notice that you are spanning two years.  If your expenses were in 2017 and you already filed your 2017 tax return and claimed the expenses, but the HSA withdrawal was in 2018, then the withdrawal is not a taxable recovery on your 2017 return at all.  It would be a taxable recovery on your 2018 return, if it is a recovery at all.

So you really have several options.
The least good option is filing an amended 2017 return to reduce your medical expense deduction by $2000.  Amended returns just make too much work for everyone.  But if you did that, you could ignore the HSA withdrawal and continue to withdraw money in 2018 for new expenses without worrying about it.

One good option would be to send $866 back to the HSA bank now, as a "return of mistaken distribution."  That way, you don't have to worry about any future expenses.  You can withdraw for 2018 expenses or not, without having to keep track.  Not all HSAs will accept a return of mistaken distribution, and this is a special form and procedure, not a regular deposit.

The other pretty good option is to keep the money and wait and see what happens for the rest of 2018.  For example, if you had $500 of expenses and don't take any more withdrawals, then you would have a taxable recovery of $366 to report next year.  

The IRS has no way of knowing, other than random audits, that you used the 2018 HSA money for a 2017 expense that you also deducted, instead of for a 2018 expense.   If you ignore the issue, you have a decent chance of getting away with it.  That doesn't make it right, and if you do get audited, you can face penalties and interest on the back taxes.

[dadgad5651]

Thanks Opus 17...the wait and see approach will work best.

[BMcCalpin]

As I understand you, you withdrew $2,000 in 2018 in order to pay for qualified medical expenses that you incurred in 2017 (or was it 2016?) but incurred in any case after you had begun your HSA. If so, there is nothing wrong with this, except that the expenses that you paid for with HSA funds cannot be claimed on Schedule A. 

If this is what you did, then you would have to amend your 2016 return (I guess that this is the return that you took an $866 deduction on) to reduce your Schedule A medical expense deduction.

However, you need to weigh the pros and cons: on the one hand, you will have to amend your 2016 return and pay some money (866 times your marginal tax rate)...but on the other hand, the HSA administrator is going to send you a check for $2,000 out of your HSA. On the whole, this looks like a winner for you.

Note that so long as a medical expense was incurred after the HSA was created (according to your state law), then you can take a distribution at any later time (even years later) to repay yourself for the after-tax expense. 

[Opus 17]

Easier to report a taxable recovery, unless the taxpayer is in a much lower tax bracket this year.

[noodad]

@dadgad5651 it's not really a grey area. Double-dipping isn't allowed when it comes to federal income taxes.

So, you can have medical expenses reimbursed from an HSA. And you can deduct them on your tax return. But  you can't do both with the same expense. If you've already gotten an HSA reimbursement for any particular expense (or if you used your HSA to pay for it, same thing), you can't include it in your total medical expenses on your Schedule A, unless you first have it reversed by filing the relevant paperwork with your HSA custodian. Conversely, once you file your tax return, you can't take an HSA reimbursement for any expenses you've already deducted on your Schedule A.

Obviously, it's pretty easy to make mistake here, so there are ways of correcting it once it's discovered. But it's still not allowed.