HSA contributions with with FSA

[CluelessCamper]

Background:
* My benefits year is May 1, 2024 - Apr 30, 2025.  
* I have an HDHP with HSA from my employer
* My employer contributes $250/mo to the HSA whether I contribute or not.
* I have been matching that contribution of $250/mo

* My wife enrolled in an FSA plan at her employer which started in Jan 2025
* My wife's benefits year is Jan-Dec. 

What I've learned in the last month is that her FSA starting in January made me ineligible to contribute to the HSA in 2025.  Her employer won't let her unwind the FSA, so I'm stuck with it.  I can obviously stop my contributions to the HSA, but I (and my employer) have already contributed for 4.5 months this Tax year.  All the money is still there.  We haven't spent it and I've stopped using the money in the account until this is settled.

I think these are my options, please correct me or point out any others:

1. Mark myself ineligible at my employer. This will stop theirs and my contributions.  Then, file the excess contribution form for both our contributions made from Jan-now, before filing for TY25.  This means I'll technically lose some of my total compensation because they won't shift the remaining HSA payments to my regular income (I asked).  Not great, but it's not the end of the world.  
2. Same as option 1, but I ask the HR dept to instruct the HSA administrator to return their contributions.  Then I just have mine to file for excess.
3. Set my contribution moving forward to zero.  Allow my employer's contributions to continue and file an excess contribution form to withdraw all the money that went in there from Jan-Dec prior to filing my TY2025 return.  I think this means I'll just have to pay taxes on that income like it's regular income.

Is there anything I'm missing?  I've a pretty solid grasp of basic taxes, but this is above my head.  What penalties should I be looking forward to?  I presume I should adjust my witholdings to account for increased AGI from the excess contributions, but is there anything else I need to prepare for?

[Opus 17 · Accepted solution]

You are correct that you are ineligible to contribute for all of 2025 because of your spouse's FSA.  

You can spend the money already in the HSA if you have qualified medical expenses.  The rules for spending are separate from the rules for contributing.  If you can spend the money for qualified medical expenses before Dec 31, 2025, you will avoid any penalties.

You should stop any voluntary contributions ASAP.  You should also tell your employer you are not eligible for their free matching contribution. 

The ineligible contributions (both voluntary and employee) will be added to your taxable income at the end of the year, because they are not eligible for a tax-free contribution.  However, there is no additional penalty for making the contributions. 

If you have funds remaining in the account at the end of the year that you are unable to spend on qualified medical expenses you have two options:

A. leave them in the account and pay a 6% penalty.  This might be a good choice if you plan to be HSA-eligible in the future (such as your wife declines the FSA for 2026) because you can apply the excess contriubiton from 2025 towards your 2026 limit.

B.  remove the funds from the account by asking the bank for a "return of excess contributions".  The returned contributions are not taxable again (because you lost the tax deduction for the contributions already) but you would have to report as taxable income, any interest you earned on the excess.

But, if you can use up the excess with qualified medical expenses, there won't be a 6% penalty because the penalty is charged on the amount of excess contribution or the remaining balance, whichever is less. 

[Opus 17]

I will also point out that stopping the free employer money is between you and the employer.  If you continue to take the free employer money, you will have money in the HSA to pay for medical expenses or withdraw as excess.  It will be added to your taxable income (as if your employer had given you a raise instead of putting money in your HSA) but you won't pay a penalty if you spend it for qualified medical expenses or withdraw it as excess contributions.  The IRS does not require you to send the money back to your employer.  Any obligation to your employer is between you and them only.  (For example, if you have to certify you are eligible to get the free money, you might get in trouble if you don't tell them otherwise.  But that's between you and them, the IRS doesn't care.)

[CluelessCamper]

Thank you.  That makes the most sense of all the things I've read about this.  My plan is to mark myself ineligible, eat the pay-cut from the loss of their contributions for the year, and then adjust my withholding (or trad/roth contributions) to account for the added taxable income.  As for spending the money, I'm sure that won't be an issue.