Opus17, thank you for the information. I want to respectively push back here for a minute so please hear me out.
I just looked up Box 3 codes and "1" indicates a normal distribution. Isn't the whole point of identifying the excess back in 2022 addressing the fact that the money should have never been in the HSA in the first place which therefore would mean that it doesn't matter whether or not the funds are used for medical or not. I did pay income tax on the excess and a 6% excise tax penalty for the overage. I continued to pay that 6% excise tax each year the funds are in the account.
The below is directly from the IRS instructions for form 8889. Nowhere under "Distributions From HSA" does it reference a 20% penalty relative to excess funds used for non medical. The IRS knows the funds aren't for medical because they should have never been in the HSA in the first place, hence the excise tax penalty and also why form 1099-SA has a code specifically for excess contributions. I think where we agree is that for 2025, there shouldn't be any excise tax since there is no longer excess (6% x zero = zero). Where I am challenging you is why is this distribution subject to income tax again? The excess was pretax when it went through payroll back in 2022. When i filed my 2022 taxes in 2023, I identified the excess in the HSA and that excess was subject to income tax in the return I filed in 2022. Explain to me why I would pay income tax again on this distribution in 2025? Where is the authoritative guidance that supports your statement on the income tax? I believe I have ruled out the 20% penalty based on review on the IRS form 8889 and the definitions of the distribution codes.
Distributions From an HSA
Distributions from an HSA used exclusively to pay qualified medical expenses of the account beneficiary, spouse, or dependents are excludable from gross income. (See theLine 15 instructions for information on medical expenses of dependents.) You can receive distributions from an HSA even if you are not currently eligible to have contributions made to the HSA. Any part of a distribution not used to pay qualified medical expenses is includible in gross income and is subject to an additional 20% tax unless an exception applies.
@ktramo17
You have to look at the instructions and form 8889 and 5329 (part VII).
To remove an excess contribution after the normal deadline so it is no longer taxed, look at the calculation on lines 43-47 of form 5329. The specifically references that withdrawals from the HSA that are reported on line 16 of form 8889 are removed from the excess contribution carry over.
Then line 16 of form 8889 is taxable distributions because they are more than your qualified medical expenses. And of course, taxable distributions are added to schedule 1 line 8f with a 20% penalty on schedule 2.
A withdrawal of excess from 2022, that is made is 2025, can't be coded as a "withdrawal of excess" under code 3, because the procedure for withdrawal of excess only applies if the withdrawal is made before the tax deadline (including extensions) for the year in which the excess contribution was made. That would be April 15, 2023 or maybe October 15, 2023, but by 2025 it is much too late to use that procedure. You can only make a regular withdrawal. And the way to use that regular withdrawal to clear the penalty is to not use it for medical expenses, so it is reported on line 16 of form 8889, which flows to line 44 of form 5329.
