Tag Archives: Penalty

Remove Amount Greater than Excess Contribution from HSA

This question was sent in by HSA Edge reader Dale. Feel free to send in your own question.

I was only eligible for an HSA in 2018 for July and switched health plans immediately after my contribution. I contributed $685 which is more than 1/12 of my allowable amount ($371). If I request an Excess Contribution Reversal for the entire $685 + interest, am I allowed to consider my entire $685 as Other Income and just pay income tax on it?

Making and Removing Excess Contributions

Each year, the IRS determines the contribution limit, or maximum amount, one is allowed to contribute to the HSA. However, note that your contribution limit may differ from the IRS limit. Reasons that this may differ are:

Partial year HDHP coverage
Medicare coverage (including retroactive coverage)
Flexible Spending Account (FSA) or other health coverage
Employer Contributions counting towards your limit

Anything above your personally calculated contribution limit is considered an excess contribution. Excess contributions are not good – in effect, you have exceeded the tax deduction afforded you by the IRS. The IRS likes to collect what is due to them, so, understandably, frowns on this.

You can remove excess contributions from your account in the tax year they occur without penalty.

Luckily, there are options to correct Excess Contributions after they occur. This involves removing your excess contribution from your HSA before the tax date of a given year. For most people, this is mid April, though extensions do apply. If excess contributions are not removed, a 6% penalty is due each year for as long as the excess contributions remain in the account. This can add up over time.

You are correct that you can remove the excess contribution for 2018 up until your tax filing deadline (with extension). Per Form 969:

HSA-excess-contribution-removal-IRS-rules

Removing non-Excess Contributions

However, one very important point is that you cannot just remove funds willy nilly from you HSA. In your above example, you contributed $685 compared to your contribution limit of $371. This means you have a $314 excess contribution that can be removed. The whole $685 cannot be removed without penalty.

Any funds removed from your account that are not excess contributions face penalty and tax.

The IRS is firm on the fact that once funds go into the HSA account, they are to be used for medical purposes. Besides excess contribution correction, any removal of funds from the account are considered “Non Qualified Deductions”. Per IRS 696:

HSA-non-qualified-distribution-tax-and-penalty

Note that the above text “not used for qualified medical expenses” is incredibly broad. It includes any sort of scenario, other than removing excess contributions, where HSA funds are coming out of your HSA and not being spent on qualified medical expenses. This comes up often from readers as they assume they have flexibility to contribute / distribute from the HSA as they see fit. The IRS does not agree, and once the money goes in, it is not easy to just take out. Thus, care and planning should occur for calculating how much to contribute to your HSA during a year.

Calculating Non Qualified Distribution Penalty

Removing funds from the HSA not spent on medical expenses is costly. If this applies to you, see our article “Can You Cash Out An HSA?” for options on getting the money out.

If the penalty is indeed due, you will need to pay both tax and penalty on the amount. This sort of makes sense – the IRS is 1) undoing the tax benefit you got from the initial contribution and 2) penalizing you for not following the rules. This assessment occurs in Part 2 of Form 8889 under “HSA Distributions”. Here is what that section looks like:

Form-8889-HSA-Distribution-Penalties-and-tax

As you can see above, assume you have a non qualified or “excess” distribution that came out of your HSA. #1 indicates where your non qualified distribution is added to income and is taxed. #2 indicates where the 20% penalty is calculated and added to your tax bill due.

Overall, it is an expensive way of getting your money out. Plan accordingly.

Note: If you want help calculating your distribution penalties and preparing your HSA tax forms, please consider my service EasyForm8889.com. It asks you simple questions and fills out Form 8889 correctly for you in about 10 minutes.

HSA Non Qualified Withdrawal Tax and Penalty

This question was submitted by HSA Edge reader Adam. Feel free to send in your question today to evan@hsaedge.com.

I have had an HSA for 7 years and have a balance of $7k in the account. If I need to access this money for non medical expenses, what are the penalties I will pay? What are the income taxes, do I pay a taxes on the penalty, and how do I pay this?

Withdrawing Funds from an HSA

Contributions to Health Savings Accounts are intended to be used for qualified medical expenses. If used in this manner, they offer a triple tax advantage that saves you money by decreasing your taxes. However, life presents a lot of challenges, and sometimes you need to access and use your HSA money for other things. In IRS speak, this is called a non-qualified withdrawal, and basically means taking out HSA money for non medical use. This could be anything from a bike, to a vacation, to home appliances. The point is that you need to declare this usage of money since it isn’t abiding by the HSA rules. While the IRS let’s you get your money out, the drawback is you will owe taxes and penalties on this withdrawal.

Before taking a penalty hit, be sure to review all the ways to cash out your HSA. Perhaps you can get creative and avoid taxes and penalty.

Non Qualified Withdrawal – Tax Calculation

First up, you are going to need to pay taxes on your withdrawal. This is reasonable since the funds you contributed were tax free – you got a tax deduction when you contributed them. That tax deduction was predicated on the funds being used for medical purposes, and since that is not the case, it seems fair to pay that tax benefit back. This calculation first occurs on Line 16 of Form 8889. Here, you take you total HSA distributions (Line 14, net) and subtract qualified HSA distributions (Line 15). The result is non qualified distributions, Line 16, also called “Taxable HSA Distributions”. This amount will make its way Form 1040 and be added to income, thus increasing your taxable income for the year. This will either increase your taxes owed or reduce any tax refund.

2017 Form 8889 created using EasyForm8889.com
HSA-Form-8889-Taxable-Distribution-penalty

The actual amount of income taxes you will pay is determined by your marginal tax bracket. The US income tax system is progressive meaning it consists of increasing tax rates in brackets, which are ranges of income amounts. The result is each additional dollar you earn is taxed at your highest rate. For example, if you make a non qualified distribution of $1,000 and are in the 25% tax bracket, you show that extra $1,000 as income and will owe taxes of $250. Note that this marginal tax rate differs from your average tax rate for the year, which is a weighted average of your income in various tax brackets.

Non Qualified Withdrawal – Penalty Calculation

After the taxes, the bad stuff starts happening. Most unfortunately, the IRS penalizes non-qualified withdrawals a whopping 20%. This means that besides taxes, for every $1,000 you take out of your HSA for non medical expenses, you will owe a fee of $200. That is an expensive price to pay to get your money, but sometimes it is worth it.

Back on Form 8889, Line 17b multiplies that “Taxable HSA Distribution” amount by 0.2, i.e. 20%. The result is the amount of penalty you will have to pay to the IRS. This amount makes its way to Form 1040 Line 62 where it is added as a penalty in the form of an additional amount due for the year.

The good news is you do not pay taxes on the penalty amount. As you can see above, the tax amount was calculated and then the penalty amount was determined. Said another way, the penalty calculation is a function of the taxes due, not the other way around. In terms of when this payment must occur, note that all HSA penalties and taxes are payable when you file taxes in the year the non-qualified distribution occurs. This is almost always in the future, so you have until April of the following year to find that tax and penalty amount and pay it to the tax man.

Note: if you have non qualified withdrawals this year, please consider using my service EasyForm8889.com to help complete Form 8889. It is fast and painless, no matter how complicated your HSA situation.

Correct HSA Excess Contribution from Prior Year

This question was submitted by HSA Edge reader Sue. Feel free to send in your question today to evan@hsaedge.com.

I made a contribution on 12/29/16 of $3,000, however, I was not HSA eligible in 2016. How can that be corrected to reflect the correct tax year of 2017? The trustee could not correct it. Should my CPA refile 2016 taxes to report the correction?

Excess Contributions

HSA excess contributions occur when an amount greater than the account owner’s contribution limit is contributed to the HSA. It sounds like you made an excess contribution in 2016 as you were not HSA eligible. While you would like to move that contribution for 2017, it is currently September of 2018, so that tax year is likely closed.

Generally, the remedy for excess contributions is for the account owner to remove the excess contribution from the account before taxes are filed taxes for that year. This can be done on Form 8889, see “Correcting HSA Excess Contribution on Form 8889“. I don’t believe the custodian can fix it for you. That would involve them saying, “This contribution wasn’t for 2016 it was for 2017”. I don’t believe they can roll a contribution forward like that. The only time they can do that is to reclassify a contribution as a prior year contribution, as in, “This 2018 contribution was made before my tax deadline (contribution cut off) and I want it to reclassify it as a 2017 prior year contribution”.

To avoid headaches, remove Excess Contributions in the year they occur.

In your case, since that excess contribution removal did not happen, you may have misstated your 2016 tax returns if you did not pay taxes on that HSA contribution. Said another way, you likely took the HSA deduction on $3,000 when your contribution limit was $0 as you were not HSA eligible. This means you underpaid taxes on that $3,000 of income in 2016.

Leaving Excess Contributions in your HSA

The IRS imposes a penalty for leaving excess contributions in your HSA. This is called the excise penalty and amounts to 6% of the excess contribution per year it remains in the account. Per Form 969:

Generally, you must pay a 6% excise tax on excess contributions (see Form 5329). The excise tax applies to each tax year the excess contribution remains in the account.

So besides having tax deduction headaches, the IRS throws in a yearly penalty on the amount of the excess contribution.

Correcting Prior Year Excess Contributions

Correcting prior year HSA excess contributions involves moving the contribution from when it was excessive to when it was allowed. However, this tricky because it affects tax forms and involves both 1) correcting tax deduction (i.e. paying taxes) and 2) paying the 6% excise penalty in prior years. The procedure is to go back to the source, pay any taxes on the excess contribution, pay any penalties up until contribution is allowed, and then take the contribution in the allowable year. You will receive the HSA deduction when you remake the contribution, so that at least offsets paying the taxes in the prior year.

Correcting prior year HSA excess contributions involves moving the contribution from when it was excessive to when it was allowed.

In summary, I believe the way to correct your situation is to:

Restate 2016 income tax form to remove HSA deduction
Pay 6% excise tax on excess amount in HSA in 2016
Pay 6% excise tax on excess amount in HSA in 2017
Take deduction for contribution in 2018 for amount already in HSA, assuming you still have HSA coverage.

[Note that if you filed an extension for 2017 you may still be able to make the HSA contribution for that year and avoid #3 above.]

Deduct Excess Contribution in a later year

Form 969 also allows you to deduct the excess contribution in a later year. This means that you made an excess contribution in a prior year, did not take the tax deduction then, left it in your account, and later use that amount as a valid contribution in a later year. You thus receive the tax deduction for that year. This option is utilized in step #4 of the solution above. Form 969 states:

You may be able to deduct excess contribution for previous years that are still in your HSA. The excess contribution amount you can deduct for the current year is the lessor of 1) Your maximum HSA contribution limit for the year minus any amounts contributed to your HSA for the year and 2) the total excess contributions in your HSA at the beginning of the year.

Note: if you need help excess contributions this year, please consider using my service EasyForm8889.com to help complete Form 8889. It is fast and painless, no matter how complicated your HSA situation.