HSA refund

[Danyah33]

Last week, I received a refund for a medical procedure that I had paid through an HSA.  This had come up a couple of times before, and I merely returned it to the HSA as a return of a previous withdrawal (there was a form to fill out, or something).  This time, it's a bit more complicated--the HSA from which the funds were drawn no longer exists, and the procedure was performed in 2017!  How do I submit it as a return of a previous withdrawal if it wasn't taken from my current HSA?  Am I just stuck declaring it as income?  It's certainly not going to fall within the correct calendar year.  Any suggestions?  Thank you in advance.

[BMcCalpin]

If you can't apply the refund to qualifying medical expenses in 2019, then, yes, you will likely have to declare the refund as income and not only pay income tax but also a 20% penalty in tax year 2019. However, you have two alternatives:

(1) Do you have (or will you have) any medical bills before the end of calendar year 2019? If so, pay these bills with the refund. Keep the receipts and document what you paid with the refund in case the IRS ever asks.

(2) Were there any medical bills in the past (but incurred since the HSA was created) that you paid with after-tax dollars? If so, apply the refund to this amount, as if you requested a reimbursement of HSA finds for prior year expenses. Note, it doesn't matter how far you go back, so long as the expense was incurred after the HSA was created (generally, the date of the first contribution). If you can do this, then document the receipts and what you did in case anyone ever asks.

No, this isn't exactly the right process but since, to my knowledge, the IRS has not addressed the situation of a mistaken distribution from a closed HSA (perhaps someone will update us on this), and since the net effect on your tax benefits is the same as if you returned the "mistaken distribution", and since you have documented all this (right?), you should be OK if anyone ever asks.

Otherwise, to stay on the right side of things, you would probably have to declare any part of the refund that was not charged off to qualifying medical expenses to your income in 2019, and pay the income tax and penalty.

[dmertz]

A return of mistaken distribution does not have to be in the same calendar year as the distribution.  It only has to be accomplished " no later than April 15 following the first year the account beneficiary knew or should have known the distribution was a mistake."  To do a return of mistaken distribution in this case would require the HSA administrator involved to reopen the HSA, accept the return of this mistaken distribution and issue a corrected 2017 Form 1099-R.  However, since an HSA is not required to accept a return of mistaken distribution, it's likely that the HSA administrator will decline to accept this one, given the circumstances.

[BMcCalpin]

"perhaps someone will update us on this" - @dmertz you are just who I was thinking of 😉

Lacking the OP's ability to convince the original HSA custodian to reopen the HSA and accept the mistaken distribution, am I correct in thinking that applying as much of the refund as possible to current and prior qualifying medical expenses is about the only way to avoid declaring the refund as income at the end of tax year 2019?

[dmertz]

Yes, that seems reasonable to me, however, the IRS hasn't really provided any guidance with regard to this sort of situation where a refund was obtained that cannot be returned to the HSA.  It seems seems reasonable that the refund would be taxable if not applied to medical expenses.  IRS Notice 2004-50 Q&A-37 discusses the tax treatment if the HSA accepts the return of the mistaken distribution but does not explicitly address what happens if the mistaken distribution is not returned.   One can infer that the mistaken distribution is subject to tax and potential early distribution penalty if not used for qualified medical expenses, but it does not address how to apply it to qualified medical expenses or to even identify what medical expenses would be considered to be qualified medical expenses under these circumstances.  There is certainly no problem treating as qualified medical expenses those incurred before the original distribution from the HSA.  The only question is what medical expenses incurred after the original distribution might be considered to be qualified medical expenses to which the refund can be applied.  It seems reasonable that one would be able to apply the refund to qualified medical expenses incurred between the time of the original distribution and the time of the refund since the recipient did not have control of the funds during that time.

Applying the refund to medical expenses incurred after receipt of the refund is more questionable, but would still seem to satisfy § 223(f)(1) which simply says that to be nontaxable that the distribution from the HSA must be used for qualified medical expenses.  However, that interpretation would suggest that anyone could take a distribution from and HSA at any time to apply in the future to medical expenses not yet incurred and not have it be taxable, which seems unreasonable.  I am not aware of any case where the IRS has audited the medical expenses to which an HSA distribution has allegedly been applied, but that doesn't necessarily mean that it hasn't happened.

With regard to my own HSA I keep some qualified medical expenses in reserve by paying them without using a distribution from the HSA.  This provides me with a buffer against which I can apply an otherwise mistaken distribution at some time in the future while keeping a larger balance in my HSA to grow tax free.  I have a set of folders where I keep records of all qualified medical expenses with respect to the HSA, both those already paid from the HSA and those incurred after the establishment of the HSA but yet to be paid from the HSA to be able to document the application of HSA distributions to qualified medical expenses.