Employer contributions on Ineligible HSA employee?

[SR5060]

My wife and I switched to an HSA eligible health plan mid year where the employer contributes $2000 towards expenses. What we realized a few months later was that my pre-existing health FSA of $400 made us ineligible to contribute to an HSA, we since corrected our contributions to make zero HSA employee contributions for the year. However now that I am prepping our taxes for 2022 I am wondering if the employer contribution of $2000 was also ineligible for us? 

If it turns out that the employer contribution is dis-allowed, then our added complication is that we spent about half of that money already on (eligible) expenses, so we are not able to simply withdraw the money fully as an overcontribution. What is the most appropriate way for us to correct this? 

[BrittanyS]

Typically no, you can not have a health FSA and an HSA at the same time, even if your employer is the one making the contributions.  

There are a few exceptions:

1.   limited-purpose health FSA, which pays or reimburses expenses only for preventive care and “permitted coverage” (e.g., dental care and vision care). 
2. Another HSA-compatible arrangement is a post-deductible health FSA, which pays or reimburses preventive care and other qualified medical expenses only if incurred after the minimum annual deductible for the HDHP under § 223(c)(2)(A) is satisfied.

To contribute to your HSA, your FSA must be set up as one of the above options.  If your FSA were not established as one of the above, you would need to request a withdrawal of any remaining funds in the HSA to reduce any overlapping penalty.  

[SR5060]

@BrittanyS  thanks for the feedback. based on reviewing IRS publication 969, it states: 

Page 8 regarding excess contributions:

"If you fail to remain an eligible individual during any of the testing periods, discussed earlier, the amount you have to include in income isn’t an excess contribution. If you withdraw any of those amounts, the amount is treated the same as any other distribution from an HSA, discussed later."

I am confused on how to interpret this. it sounds like the money isn't classified as excess contributions, so I can simply withdraw early and count as other income in the 1040, however if it's "treated the same as any other distribution from an HSA" then how do I report this appropriately? do I simply report all of the pre-tax dollars in form 8889 part III as income and pay the 10% penalty, even if I withdrew it prior to filing?

[BillM223 · Accepted solution]

"If you fail to remain an eligible individual during any of the testing periods, discussed earlier, "

The two testing periods discussed earlier were for (1) using the last-month rule, and (2) a qualified funding distribution, neither of which applies to you. 

In your case, you have an excess contribution that you are unable to withdraw (a not too uncommon occurrence).

The excess that you are unable to withdraw will carry over to the next year. Normally, this would reduce your HSA limit next year, but this would matter only if you were still eligible to contribute. 

NOTE: you would have to withdraw all contributions, both yours and your employers.

So you have two choices:

1. Arrange things so that you do not have FSA coverage next year. This would allow you to resume contributions to the HSA in the subsequent year, and "use up" the carryover of the excess. You will need to sit down with your benefits people and see if you can get out of the FSA...in writing.

Note: the carry over will be done automatically by TurboTax and will cause a 6% penalty.

2. Make a distribution from the HSA for the amount of the carried over excess (i.e., call the HSA custodian). The excess would be added to your income for tax year 2023, along with a 20% penalty. Once, however, you have done this, the carry over is done with.

I don't know your specific situation, but I would investigate asking to be removed from the FSA (If possible) and going full-tilt into the HSA. Not only is the contribution limit for the HSA much higher, but you don't have any "use it or lose it" rules for the HSA. Instead, the HSA becomes a unique piggybank wherein all money going in is tax-free and all money spent out of it on qualified medical expenses is also tax free...AND all earnings in the HSA are tax-free. There is hardly any better deal tax-wise in the Tax Code. You know that you will eventually have to spend money on medical stuff, and it's nice to know that you have that tax-free medical expense piggybank there.

P.S. The HSA belongs to you, not your employer...so even if you leave your employer, you take it with you.

PPS, It's odd that your employer would offer HDHP health insurance coverage AND an FSA...is it possible that they are on the way to dropping the FSA?

[SR5060]

@BillM223 

The issue was we changed health plans mid year from a non-HDHP to an HDHP when my spouse switched employers. at the beginning of the year, I had set up an FSA through my employer and hadn't caught the conflict at the time of our qualifying event. We have since corrected this for 2023, so the eligibility is good to go moving forward. 

I thought the last month rule would apply to us but it sounds like I am maybe over complicating the situation and can just defer the excess contributions to next year and take the (much more palatable) 6% excise tax on the overcontributions we didn't already withdraw. It sounds like we don't need to handle the carryover in any special way for it to count for next year then?

[BillM223]

Please let me confirm, you are going forward with the HSA or the FSA in 2023?

If you will have only the HSA in 2023, then what you will need to do is make sure that between you and your employer (and your spouse and anyone else) that you do not contribute more than your 2023 annual HSA contribution limit MINUS the carryover. That is, you have to leave room for the carry over to be "used up" in 2023. If you contribute the full HSA contribution limit in 2023, you will just cause another excess contribution problem and perpetuate the problem, 6% each year.

If you have an FSA in 2023, then we have a different problem - you can't use this method (above) to use up the carry over, so you will pay 6% excess tax every year. Forever.

The way you fix the carryover in this latter case is by taking a distribution from the HSA for the amount of the carryover (i.e., calling the HSA custodian and asking for a check for that amount). This amount is added to your Income, along with a 20% penalty...but at least the carryover stops in the year that you do this.

[SR5060]

@BillM223 

we are moving forward with the HSA, the FSA was inactivated at the end of 2022. I understand the overage will count towards the 2023 HSA contributions but do I need to do anything specific to appropriately report that prior year contribution (either in 2022 tax filings or 2023?)

[SR5060]

nevermind, I just realized that's captured in form 5329

[Birdd]

I couldn't find the term in form 5329, could you give a quote from the instructions?