Withdraw excess HSA contribution of Tax Year 2021 (3 Years Ago)

[jzh]

In 2021, I had excessive contribution of 500 dollars due to job change. And I just sent the withdraw request to the HealthEquity in 04/13/2024. (Due to some misunderstanding, I didn't do that in 2022). It seems I can only get the 1099 SA in 2025, so does it mean the only options I have is to pay the 6% penalty this year and get those excess contribution removed in 2025 for Tax Year 2024?

I take a look at the forms, it seems there is a question in Line 2 Smart Worksheet B in Form 8889 asking Excess HSA contributions withdrawn before April 15, 2024. But I cannot find a way to fill this out by answering the Turbo tax HSA questions. (Maybe this is only for withdraw of excess contribution made at 2023?)

Another question I have is regarding the code-2/code-1 1099 SA I would get in 2025 after I read the following posts: 

1. HSA Excess Contribution from 2020 Question

2. Withdraw excess HSA contribution after 2 years 

3. Reporting Excess HSA Contribution return 

It seems from the HealthEquity the withdraw will be most likely result in the code-2 1099 SA. However, people are suggesting it should be code-1 simply because of the excess amount should be taxable given it's pre-tax money. While the post 3 mentioned that Turbotax would automatically put the excess amount in the Other income of Schedule 1 if it detects it. I checked my tax filing packages in 2021, the $500 do show up in 1040 item 8 as taxable. Isn't that mean the code-2 1099 SA form is working as intended? Am I missing/misunderstanding those posts?

Thanks and appreciate it!

[dmertz]

A distribution in 2024 to correct an excess contribution made for 2022 must be a regular distribution, reported with code 1 on a 2024 Form 1099-SA, and not claimed as used for medical expenses. 

However, I think that you might be correct that HealthEquity will mistakenly issue a Form 1099-SA with code 2, I think I've heard of them making this mistake before.  To avoid confusion, it probably would have been better to have just requested a regular distribution instead of mentioning to them anything about an excess contribution.

[jzh]

Thanks for the reply and really appreciate it.

May I know why it should be code 1? Shouldn't I already paid the tax in 2021 as Other Income for the $500. So I only need to pay the tax for the Earnings for excess contribution, which is the box 2. Or is it because of the 20% penalty has to apply to the $500 as well since it is a non-qualified distribution? 

Regarding my first question, it seems because my Box 12 data of W2 is not recognized by the TurboTax. After I correct it, now I saw something meaningful. Now this $500 is specifically marked as can't withdraw and 3 options are given by the TurboTax help:

1. Simply take a non-qualified withdrawal of the excess amount. This distribution will be taxable ad subject to 20% penalty.

2. Take qualified withdrawal (for medical expenses) that take your HSA balance down to $0.

3. Simply apply the excess contribution to the next Tax Year contribution limit. That seems to be just contribute $500 less than the 2024 HSA contribution limit.

I am surprisingly find people didn't mention option 3 at the first time, so maybe there is some issues with it? Would love to hear your opinion on those. Thanks! 

[dmertz]

Part of the penalty for failing to correct the excess contribution timely is double taxation of the excess amount.  After the due date, including extensions, of the tax return for the year of the excess contribution, the excess can only be corrected by obtaining a taxable distribution from your HSA.  You can see this on line 44 of Form 5329 which comes from line 16 of Form 8889.

Option 3 is only a possibility if you are eligible to make an HSA contribution for the later year.  For those who have made excess HSA contributions, a large number of people did so without considering that recently acquired Medicare coverage made them ineligible to contribute and will never again be eligible to contribute, so the option to apply an excess as a future year contribution doesn't come up.  In your case, you said that you already requested a distribution of the excess, so I didn't mention Option 3.

Regarding Option 2, that eliminates the penalty on the excess but does not seem to eliminate the excess itself.

[jzh]

Thanks for the prompt reply, and I'll probably try to contact HealthEquity support to see if I can cancel the withdraw since I just submit the request yesterday. And option 3 seems a little bit less process needed and no additional 20% penalty (?).

And forgive me if I am being too nitpick as I still have puzzle regarding the double tax on excess amount. When I read the IRS pub 969, it seems only mention two things:

1. Excess contribution is subject tot 6% tax penalty every year if not being removed.
2. Unqualified distribution subject to income tax and maybe additional 20% penalty.

And it didn't mention whether you should pay the income tax for the year of the excess contribution is made. I also checked the instructions of Form 8889, Form 5329 and Form 1040 Schedule 1. (Both 2021 and 2023 version). They seem only mention the concept of Taxable HSA distributions from Form 1099 SA. I assume all that means we only subject to the income tax when we distribute the money from HSA for non medical purpose.

However, in tax year 2021 TurboTax just put $500 in that line 16 of Form 8889 while I haven't received any 1099 SA (I never used any of the money in my HSA in 2021). And that lead me to pay the tax for the $500.  Is it an expected behavior? Is the basis of doing this come from 'Excess contributions aren’t deductible' in pub969?

Something probably make more sense to me is, in tax year 2021, no distribution happens, so should be no Taxable HSA distributions for the $500. And the real distribution happens at 2024, which I'll expect to get a 1099 SA for Tax Year 2024. Then you paid the income tax and penalty for the $500 because you withdraw it as pre-tax money. In that situation, I totally agree with you that we should use the code 1 for 1099 SA. But given I paid the tax already, shouldn't the income tax just apply to the earnings (code 2)? The publication seems vague about whether we are expecting the double tax.

If you didn't mind to give me some detail explanation, I would be super appreciate it. Thanks again for really taking time on this. 

[dmertz]

Line 16 of Form 8889 is in Part II, the HSA Distributions section, so an amount on line 16 of Form 8889 can only come from the entry of a Form 1099-SA that reports a distribution made taxable by not applying it to medical expenses.

Excess HSA contributions are not permitted to be excluded from income.  If the excess contribution was a personal contribution (not through an employer), you don't get to deduct the contribution.  It the excess contribution was through your employer, the employer would have excluded the amount from box 1 of your W-2, so the amount needs to be added back to income.  Because the excess amount was not deducted or excluded from income, the excess in the HSA came from after-tax money.  If the excess is corrected with a distribution after the due date, including extensions, of the corresponding tax return, that distribution must be treated as taxable, subjecting this after-tax money to a second taxation.  If you received no HSA distributions in 2021, it seems that you filed in incorrect 2021 tax return that you should amend.

If you are eligible to contribute to an HSA for 2023 and you did not already max out your 2023 HSA contribution, you can apply some or all of the $500 as part of your 2023 contribution.  Otherwise, if you are eligible to contribute to an HSA for 2024, you can apply the $500 to part of your 2024 contribution.