This is the way the system is supposed to work:
The IRS considers HSA distributions (1099-SA) to be income UNTIL you show that they were all for qualified medical distributions. Therefore, TurboTax adds your distributions to Other Income (Line 8 on Schedule 1 (Form 1040)...briefly.
When you indicate a few screens later, after you indicate that all the distributions were for qualified medical expenses, then TurboTax recalculates the tax due by removing the distributions from Other Income. This is why we stress that you need to go all the way to the end of the HSA interview to give TurboTax to perform this recalculation.
You say that your federal refund is still decreased. Was it because of the distribution or something else? TurboTax is always doing stuff behind the scenes that can make it difficult to see why it is doing what it is doing.
Your test on whether the HSA distributions are being taxed is to look at your return and see if the distributions are on Line 8 of Schedule 1 (Form 1040).
To see this, since you are using the desktop software, please go to the top to View, click on it to expose the link for Forms, and click on Forms. Then, on the left, scroll down (not far, it's one of the first forms) to look at Schedule 1. If there is a Schedule 1, look to see if line 8 has an entry that says something like "Health Savings Account" and your distribution amount. This is a sign that your distribution is being taxed. (Note: a very similar thing happens if you have excess HSA contributions).
If you see this and you know that you marked that all the distributions were for qualified medical expenses, then it is likely that the distributions have become "frozen" as income. The best way to resolve this is to do the following under ***HSA Reset***.
If you don't see such an entry on line 8 or if you don't see a Schedule 1 at all, then the distributions are not being taxed.
***HSA Reset***'
1. make a copy of your W-2(s) (if you don't have the paper copies)
2. delete your W-2(s) (use the garbage can icon next to the W-2(s) on the Income screen
*** Desktop***
3. go to View (at the top), choose Forms, and select the desired form. Note the Delete Form button at the bottom of the screen.
*** Online ***
3. go to Tax Tools (on the left), and navigate to Tools->Delete a form
4. delete form(s) 1099-SA (if one), 8889-T, and 8889-S (if one)
5. go back and re-add your W-2(s), preferably adding them manually
6. go back and redo the entire HSA interview.
[Edited 4/1/2020 11:48 am CDT - updated for 2020]
