I contributed to an HSA for 2 years but learned I was ineligible. How do I avoid the worst penalties?

[paulfrost]

URGENT?: I think I need an answer before December 31, 2024, about 1 particular question which is:
Do I need to pull the money from the HSAs that I contributed to in 2023 before the end of 2024 so as not to incur a second 6% penalty on those "excess" contributions, or will that rash decision mean that I also incur a 20% penalty for a non-qualified withdrawal from two HSAs I wasn't eligible for in the first place? (I plan to use TurboTax Live Help to walk me through some of this, but they don't offer that service until January 8th, which I fear will be too late.)
 
Here's the backstory: I opened 2 HSAs; one for my spouse and one for myself in 2023. I maxed out contributions for 2023 and nearly maxed out in 2024 before realizing in November of 2024 that our health plan in both years was ineligible for an HSA, despite the insurance provider telling me in 2023 that it was eligible. I went through this article for initial guidance: https://ttlc.intuit.com/community/tax-credits-deductions/discussion/re-i-contributed-to-an-hsa-for-y...

Unfortunately, I wasn't quite able to tease out what my steps should be.
 
We've been using my spouse's HSA account to pay for most of our and our kids' medical expenses, and have largely left mine alone, though not entirely. So I immediately filed a Return of Excess Contributions with my HSA provider for the entire sum of the 2024 contributions to my account, and left the rest in the account (My understanding is that it's too late to file such a form for my 2023 contributions, and what to do with that money is at the heart of my question). My spouse's account has less money in it than the total contribution for 2024, so I assume filing Return of Excess Contributions for her before tax time next year should zero that account out (though Fidelity mentioned something about adding a sheet to the form that redefines withdrawals for medical expenses as part of the excess contributions - I haven't found data on exactly how to do that yet). At this point, I believe we have to refile our 2023 taxes, claiming those 2023 contributions as part of our income for that year and pay a 6% penalty. For 2024, as long as I do the Return of Excess Contributions form correctly for my wife's account, we should be okay for that money. However, I will still have money leftover in my account and we will have a health plan for 2025 that is HSA eligible.
My questions are the following:
1 - Is a 20% penalty avoidable for withdrawing the money put into the HSA in 2023?
2 - Is it possible to redefine the money in my HSA (ostensibly the 2023 contributions) as 2025 contributions, thus avoiding the 20% penalty?
2a - If I do what I say in #2, I understand I may still incur a 6% penalty for the balance at the end of 2023, but will I incur a second 6% penalty for the balance at the end of 2024? And if so, can I simply withdraw the money without triggering a 20% penalty? Or is it better to leave the money alone and redefine it as a 2025 contribution once that plan activates on January 1, 2025, incurring the 6% penalty again for 2024, but at least not incurring a 20% penalty for a non-medical expense withdrawal? 



Again, I plan to use TurboTax Live help experts for this, but I worry that if I don't act before December 31, 2024, I may incur penalties I could have avoided.
 
Thanks in advance for any guidance

[Mike9241]

as Opus17 described in the link thread. your choices for what remain of the excess contributions for 2023 have to either be spent on medical expenses before the end of the year. Any money left would be subject to a 6% penalty. The other option is a nonqualified withdrawal which is subject to both a 20% penalty and income taxes.

for 2024 not only does the excess need to be removed (tax and penalty free) but if any income was earned that also needs to me removed and is subject to income taxes.

Technically the 2024 excess doesn't have to be withdrawn until 4/15/2025 and you would still avoid the excess contribution penalty, but it may be best to deal with it all before the end of 2024. 

unless already done, 2023 needs to be amended if you took an HSA deduction (or your W-2 wages reflected the HSA contribution) 

[paulfrost]

Thanks so much for responding. 

I’m not sure this works as you’re stating (the part about spending what remains on medical expenses) in my case as I was never eligible for the HSA. I don’t know how to signal that to the IRS as it’s too late to file a return of excess contributions for 2023, even though the entirety of my contributions were an excess. I guess paying income taxes on that money and the 2% late fees and 6% penalties for balances in 2023 nd 2024 will have to suffice. It is also unlikely that I will have medical expenses between now and the end of the year that total that amount in my account so withdrawing for medical expenses seems impossible and I never qualified for the account anyway. 

Based on what you’re saying, it seems like my best plan of attack, or the plan that will incur the fewest penalties is to do the following:

1- For the remaining funds in my account, leave it there until 2025 and redefine it as a 2025 contribution. Refile 2023 claiming as income and pay subsequent penalties. 
2- for the remaining funds in my wife’s account, fill out a return of excess form with the proper addendum (since what remains is lower than the excess funds, aka all of the contribution for 2024),which will bring the balance to zero. Include the 2023 contributions as income when refiling for 2023 and pay subsequent penalties. I was going to wait to talk to a tax expert about the addendum for return of excess contributions, but I see the wisdom of getting it done before end of 2024. Is the addendum likely specific to Fidelity (holder of our HSAs) or is that something a tax advisor could help with?