Why TurboTax does not add withdrawn HSA excess contribution as taxable income?

[soodye]

My situation:

• Had a family HDHP plan for two months in 2021, the rest of 10 months in PPO plan.
• So my HSA contribution limit us $1,200 (From 2/12*$7,200)
• My new employer contributed $2,000 to my HSA as a benefit (NOT deducted from my salary). That means I have $800 excess HSA contribution in 2021.
• I withdrew the $800 excess in Dec 2021.

So I entered the form 1099-SA with the excess contribution withdrawal information (gross distribution) and the relevant '2' distribution code for excess contribution withdrawal. I was expecting TurboTax to treat the $800 withdrawal as taxable income. But it doesn't, its summary on HSA summary shows $0 taxable distribution and the other amounts are correct. I appreciate any pointers and if I miss some important information about this HSA excess contribution. I think TurboTax assumes I continue to have HDHP in 2022, which would make me eligible for the full $7,200 HSA limit in 2021 (based on the full 12 months rule) and resulting in thinking I am not over contributing? If so, how do I correct it?

Thanks in advance.

[RaifH]

There are two possibilities: one is that you did not enter the months you were covered and the other is that TurboTax automatically applied the last-month rule to make you eligible for the maximum contribution.

To enter the months you were covered:

1. Go to Federal > Wages & Income > Less Common Income > 1099-SA, HSA, MSA and click Start/Revisit.
2. Make sure you have HSA selected.
3. Enter your withdrawals from your HSA by answering Yes to Did you use your HSA to pay for anything in 2021?
4. Assuming you did not inherit this HSA, select No.
5. Under Let's enter your HSA contributions your employer amount should already be in there from the W-2. 
6. Did your employer tell you about any other contributions? Answer No.
7. Answer the questions on the next two screens, making sure you answer the question related to your HDHP correctly. 
8. However, if you were covered on December 1, 2021, you are considered covered the whole year, and therefore there is no excess contribution. This is true as long as you maintain HDHP coverage for the testing period through the end of 2022. Otherwise, you will have to pay for the excess contribution on your 2022 return. 

If you did not know about the last-month rule, it is not too late to make an out-of-pocket contribution to your HSA for 2021 which will reduce your taxable income. Just make sure if you do decide to do this, you make sure it is marked as a 2021 contribution, not 2022. 

[soodye]

Thanks, RaifH.

I followed your instruction but what I got is a little different in TurboTax Premier.

After I enter my HSA information with 1099-SA information (step 2 of your instruction), I do not get the question: "Did you use your HSA to pay for anything in 2021?" - instead I am asked: "Excess contribution deducted from your wages?". Regardless of my answer yes/no, it will end the interview - and I think the answer should be no because it is a benefit contributed by my employer and no deducted from my wages.

I think you are right about TurboTax default to the last month rule. I know I won't be eligible because I switched to PPO health plan since Jan 2022 - that's the reason I withdrew the excess contribution from my employer in 2021.

Do you know any way to report the $800 withdrawal as taxable in TurboTax?

[soodye]

I think I have two options:

Option 1: If I selected the 2 months I was eligible in Oct & Nov instead of the actual Nov & Dec, then TT is doing the right limit calculation and automatically add my $800 excess contribution to taxable income. This is because the last month rule does not apply.

Option 2: Let TT does its thing and when I file 2022 tax return, it would know I had to withdraw the excess contribution in early 2021 by asking me: "Did you overfund your HSA in 2021?"

Then I would say yes and let it know I withdraw to avoid the penalty.

Does this sound like the correct approach?

I think this would have been so much simple if TT could ask do you want to apply last month rule.

[RaifH]

I would choose option 1 since you took the distribution this year and already have the 1099-SA. If you account for it next year using option 2, the 800 difference would be both taxable and subject to the 10% additional tax. 

You should answer Yes to Excess contribution deducted from your wages? Since these were contributions made by the employer, they did not get added to your income. This will add the $800 to your taxable income, plus any earnings on the excess contribution. 

[soodye]

Thanks again, RaifH.

I answered Yes to Excess contribution deducted from your wages but TT still does not add the $800 as taxable income.

So the only way with option 1 now is to substitute the December month with October to make TT include it as taxable income. However, if I do that, the Form 8889 Line 3 would also be filled with the incorrect coverage months and that feels like a false declaration. Do you have other suggestion?

I also tried option 1, then manually correct the form in form-mode, but TT then also automatically recalculates and tries the last-month rule.

[BillM223]

So how did the employer show this $2,000 on your W-2? Was the $2,000 in box 12 with a code of W? It doesn't sound like it.

So where did you enter this $2,000 if it wasn't on the W-2? Did you enter it in "personal" contributions on the "Let's enter [names]'s HSA contributions" screen? Or did you do it on the screen where you are allowed to enter contributions that the employer told you about but didn't put on your W-2?

"My new employer contributed $2,000 to my HSA as a benefit (NOT deducted from my salary)."

If your employer included the $2,000 in Wages in boxes 1, 3, and 5, then the excess should NOT be automatically added back to Other Income. The excess is added to Other Income for those taxpayers who didn't pay tax on the original excess because it had ben removed from Wages when the W-2 was printed.

So the fact that the excess is not being added back to Other Income is would I would expect (although I am still curious how you entered this $2,000 in contributions).

If you make a direct/personal contribution to your HSA, then this is not reported in box 12 with a code of W on your W-2. Instead, you enter it on line 13 of Schedule 1 (1040). This is why you see: "I was expecting TurboTax to treat the $800 withdrawal as taxable income. "

Instead, what happens is if the excess is from your direct/personal contributions, then TurboTax just reduces the amount on line 13 (from $2,000 in this case to $1,200). No need to add it back to Other Income.

And if you were covered only for October and November, then please enter only those months.

[soodye]

Thanks, BillM22. Please allow me to clarify: 

• Yes, my W2 box 12 shows W code with $2,000 contribution.
  I may have confused you with the statement "My new employer contributed $2,000 to my HSA as a benefit (NOT deducted from my salary)." It's not deducted from my salary, it's just a benefit. I don't lose or gain gross income of $2,000 as salary either I have HSA or not. If I don't have HSA, then my employer does not give this $2,000.
  For this discussion, let's treat it as deducted from gross income because it should be taxed at my marginal rate when I withdraw the cash from HSA.
• TurboTax pulls this $2,000 automatically from my W2. I didn't enter it. It is NOT personal after-tax contribution.
• I am actually covered for HDHP plan in November and December. But looks like TurboTax now automatically applies the last-month rule, hence I was proposing to enter October and November instead to not trigger the last-month rule. If I do that, then TurboTax correctly adds the $800 amount as taxable income. But this seems wrong because I am actually covered in HDHP in Nov and Dec instead. This is where I need some suggestions on how to do it properly. See below screenshot on TT forms:

If I select Nov and Dec HDHP coverage, then TT applies last-month rule and disregard my $800 excess withdrawal:

If I select Oct and Nov HDHP coverage, then TT applies the right taxable amount based on the $1,200 limit:

Thank you.

[BillM223]

"Yes, my W2 box 12 shows W code with $2,000 contribution."

If your employer completed your W-2 correctly, then this $2,000 was removed from Wages in boxes 1, 3, and 5 before your W-2 was printed. You keep repeating, "It's not deducted from my salary...", but it's either included in Wages or it's not. If your employer removed it from Wages when they put the code W amount on there, then it IS "deducted" from your salary. If your employer did not remove the $2,000 from Wages, then they should not have entered the code W amount.

I don't mean to be picky in terminology, but it's important so that we understand each other. 

"because it should be taxed at my marginal rate when I withdraw the cash from HSA."

I have no idea what you are trying to say here. There are two options (leaving aside withdrawal of excess contributions and other specialized cases): (1) spending money from the HSA on qualified medical expenses, in which case you pay no tax on the "cash withdrawn" at all, or (2) taking money out for reasons other than qualified medical expenses, in which case you not only add this distribution to your income but you also pay a 20% penalty (unless you are 65 or older).

"I am actually covered for HDHP plan in November and December. But looks like TurboTax now automatically applies the last-month rule,"

Yes, TurboTax automatically applies the last-month rule. I don't understand your concern here. Are you already not under HDHP coverage? Were you really under HDHP coverage in November and December 2021? If so, why would it be unreasonable to assume that you would not stay under HDHP coverage for 2022?

Besides, let's say that you know that you will not stay under HDHP coverage for all of 2022. Yes, applying the last-month rule to 2021 means that you don't have an excess HSA contribution for 2021 (I'll get to your withdrawal in December 2021 later). In early 2023 when you are doing your 2022 return, only if you did not stay under HDHP coverage (are you sure you won't?) would you add the excess back to income and pay a 10% penalty besides - a year later.

Now for your December 2021 withdrawal of $800, you did not have an "excess HSA contribution" at that point. An HSA is not a regular savings account that you can put money into and take money out of willy-nilly. There are definite rules, which, unfortunately, are not well presented in the IRS Pub 969. You really should not take money out as an excess contribution unless, at tax time, TurboTax or another tax software product tells you that you have an excess. In this case when you withdraw the money, your records and the HSA custodian's will match during an IRS audit - otherwise, they won't.

To the IRS, that $800 withdrawal looks like a withdrawal for purposes other than paying for qualified medical expenses, so not only should the $800 be added to Other Income but you should be penalized 20% on that $800. The only reason that TurboTax did not do this on your 1099-SA is because the HSA custodian took your word that it was an excess contribution, but it wasn't.

You may think I am being a pain, but the truth is - and I have seen it many times here in the Community - that taxpayers don't calculate their annual HSA contribution limit correctly, so they make mistakes when they take it upon themselves to take a withdrawal for the wrong amount.

"This is where I need some suggestions on how to do it properly."

To do it "properly", you will go back and mark HDHP coverage for November and December - if I understand you aright - and contact your HSA custodian and ask them to accept that the $800 was a "mistaken distribution". If they accept this (they don't have to, so be nice), you will send them the $800 and they will issue a corrected 1099-SA.

This is noted in the Instructions for the 1099-SA and 5498-SA on page 1:

"As the trustee or custodian, you do not have to allow beneficiaries to return a mistaken distribution to the HSA. However, if you do allow the return of the mistaken distribution, you may rely on the account beneficiary's statement that the distribution was in fact a mistake. See Notice 2004-50, 2004-33 I.R.B. 196, Q/A-76, available at IRS.gov/irb/ 2004-33_IRB#NOT-2004-50. Do not report the mistaken distribution on Form 1099-SA. Correct any filed Form 1099-SA with the IRS and the account beneficiary as soon as you become aware of the error." (NOTE: these are instructions to your HSA custodian in completing the 1099-SA, not you)

[soodye]

Thank you @BillM223 - I appreciate your thorough explanation.

I think I get your explanation overall - want to clarify a couple of things:

1. Yes, I am sure I won't be covered in HDHP because from Jan 2022 until now, I am already on a different health plan that do not qualify.

2. I called my HSA custodian. They said I can simply transfer the $800 contribution back as a personal contribution but they will not reissue a new 1099-SA. They said they will have all the correct record on their end. Is this the best route and no other way to avoid the penalty?

It is unclear to me if a tax payer can elect to not be considered on the last-month rule. IRS publication does not say that either: https://www.irs.gov/publications/p969

If IRS and TurboTax let me elect to not apply the last-month rule, then what I am doing now with early excess withdrawal when I know I won't pass the 12-month coverage test would seem like the correct/logical steps. What you were replying suggested otherwise, but I understand your expert opinion.

[BillM223]

"They said I can simply transfer the $800 contribution back as a personal contribution "

I am not sure what they mean by this. Are they saying that they will accept your payment of $800 as a personal contribution? That doesn't do you any favors. 

This puts your HSA balance (less any amounts taken out for medical expenses) at $2,000, right? Because of the last-month rule, you won't have an excess contribution on your 2021 tax return.

But, as you know, you will fail to maintain HDHP coverage in 2022 (since you have already gone off it). After the calculation, TurboTax will add $800 to Other Income (the amount that you would not have been able to contribute had it not been for the last month rule), and penalize 10% ($80) to boot.

Now, for another alternative. You are permitted to withdraw money from your HSA in order to reimburse yourself for any qualified medical expenses that you have not otherwise been reimbursed for. So if, for example, you can add up $800 for unreimbursed medical expenses that were incurred AFTER your HSA was created, then you would draw up this list and keep it in your tax files. If you ever got audited, and the IRS agent noticed that your records don't match those of the HSA custodian (so that $800 is a taxable distribution), you could pull out that list and say, I withdrew it to pay for these unreimbursed expenses that were incurred after the creation of the HSA. Since you would be allowed to do that, the agent would let it go.

As for Qualified Medical Expenses, the IRS in Pub 969 says:

"Qualified medical expenses are those expenses that would generally qualify for the medical and dental expenses deduction. These are explained in Pub. 502, Medical and Dental Expenses."

However, there have been some updates:

"Amounts paid after 2019 for over-the-counter medicine (whether or not prescribed) and menstrual care products are considered medical care and are considered a covered expense." This adds a fair amount that previously would not have counted.

Also, 

"Insurance premiums. You can’t treat insurance premiums as qualified medical expenses unless the premiums are for any of the following. 1. Long-term care insurance. 2. Health care continuation coverage (such as coverage under COBRA). 3. Health care coverage while receiving unemployment compensation under federal or state law. 4. Medicare and other health care coverage if you were 65 or older (other than premiums for a Medicare supplemental policy, such as Medigap).

The premiums for long-term care insurance (item (1)) that you can treat as qualified medical expenses are subject to limits based on age and are adjusted annually. See Limit on long-term care premiums you can deduct in the Instructions for Schedule A (Form 1040). Items (2) and (3) can be for your spouse or a dependent meeting the requirement for that type of coverage. For item (4), if you, the account beneficiary, aren’t 65 or older, Medicare premiums for coverage of your spouse or a dependent (who is 65 or older) aren’t generally qualified medical expenses."

For many people, the long-term care insurance premiums alone can be substantial. Of course, COBRA and health insurance while on unemployment are also expensive and would likely reach $800 without a lot of effort.

How does this add up?

[soodye]

You are awesome @BillM223 - appreciate the thorough response.

I agree with you putting back the $800 as personal contribution is not doing me any favor.

If I hear you right, you were proposing two options:

1. File 2021 return as what TT suggests now, which does not add the $800 excess contribution to Other Income. Then when I file 2022 return, I will pay the tax on $800 as Other Income + 10% penalty.

2. Use the $800 for medical purpose and keep the proof/receipts.

What I don't understand with option #2 is I still have $800 excess distribution that should not be in the HSA in the first place (hence cannot be used tax free). My understanding is this $800 spend is tax free only if it is HSA eligible money AND spend on medical needs.

I am going to just keep it simple with option 1 and pay the $80 penalty in 2023.