Incorrect handling of removal of excess HSA contribution

[hotpxl]

I used TurboTax Premier for 2020 tax year returns and I realize it made a mistake in handling the removal of excess HSA contribution.

I made too much contribution to my HSA account in 2020. When I was doing my taxes (with TurboTax Premier online version) in February 2021, TurboTax told me of this issue, and I contacted my HSA provider to remove the excess contribution. I went back to TurboTax, followed the prompt and confirmed that I removed the excess contribution, and then TurboTax automatically applied the removed excess amount to Form 1040 Schedule 1 Line 8 as "Other Income".

I think this is wrong: even though the excess contribution was made to tax year 2020, because I did the removal in February 2021, it should count as distribution for tax year 2021. In fact my HSA provider didn't provide me a 1099-SA for tax year 2020 for this exact reason. That means when April 2022 comes and I need to do my 2021 taxes, I'll receive a 1099-SA which lists the removal, and I'll have to pay taxes on it again.

Is my understanding correct? How do I correct for this?

[Opus 17 · Accepted solution]

TurboTax is correct. It’s not income for 2021 because it’s not a distribution, it’s a return of an illegal contribution, and it is returned to be included your 2020 income.  

If you earned interest on the illegal contribution, that should have also been returned to you and that would be 2021 income. It will be reported as part of your 1099-SA issued next year.

[hotpxl]

Thank you for the quick answer! But just to confirm, my corrected 5498-SA for 2020 doesn't show this removal (it still shows the full amount including the excess), and I don't have a 1099-SA for 2020 either. So there's no IRS form I can show to prove that I actually removed the excess (well except the form I sent to my HSA). Is this expected?

[Opus 17]

@hotpxl 

The situation is correct.  Because the money was actually returned to you in 2021, it will be on the 2021 1099-SA with distribution code 2.  (If you also have distributions for medical expenses, the total will be in box 1 and box 3 will have both distribution codes 1 and 2.)  However, even though it was paid in 2021 and will be reported on a 2021 1099-SA, it’s still listed as other income for 2020.  All this will get taken care of on your 2021 form 8889 and the IRS will eventually match everything up.  

However, I should have noted at the beginning that the withdrawal of excess contributions is only reported as current year income on line 8 as “other income“ if it was employer contributions— meaning contributions made through payroll deductions and representing either your own money or an employer match.  The reason the money is taxable in 2020 is that if you had not made the excess contributions, it would have been included as taxable income on your W-2.

If your excess contributions consisted of money that you contributed out-of-pocket, it should not have been added as other income. You would simply tell TurboTax that you contributed a reduced amount.