Tag Archives: Penalty

How to Determine if You Used the HSA Last Month Rule

Overview

This is a fairly common question I get from readers regarding the HSA’s Last Month Rule and how to file Line 18 on Form 8889. The question usually takes the form of:

“Did I use the Last Month Rule last year?”
“Do I owe anything for the Last Month Rule?”
“What should I put on Line 18 of Form 8889 where it says Last Month Rule?”

Luckily, it should be easy to figure out whether the Last Month Rule even applies to your tax return. The goal of this article is to explain how the Last Month Rule works, and then ask 3 questions to see how it applies to you.

What is the Last Month Rule?

Let’s start by defining some terms. The Last Month Rule is a “feature” of HSA’s that generally only applies to a year that you begin HSA eligible coverage. It states that if you are an eligible individual as of December 1st of a year, you are treated as an eligible individual for that entire year. This is a benefit as it allows you the option to contribute that year’s full contribution limit instead of a pro-rata amount. You get more tax free medical spending.

As an example, assume I began coverage on June 1st, 2016. Normally, I would only be able to contribute 7/12 (Jun, Jul, Aug, Sep, Oct, Nov, Dec) or just over half of the contribution limit for that year. But since I had coverage on December 1st, I am treated as an eligible individual for the whole year and may contribute up to the full contribution limit.

What is the Testing Period?

However, there is a catch. If you take advantage of the Last Month Rule and choose to contribute more than you normally could have (e.g. 12/12 vs 7/12 above), you are bound by the Testing Period to maintain that coverage for the following year. If you do not, any contribution above the 7/12 you were allowed is considered excessive and taxed and penalized on Line 18 of Form 8889 when you file your taxes. This is generally not good and should be avoided.

Please see this article for a more complete description of the Last Month Rule and Testing Period.

Determining if the Last Month Rule applies to you

First off, let’s relieve a lot of people from worry: if you had the same HSA coverage for each month in a tax year, you can put “0” on Line 18 of Form 8889. Since the Last Month Rule applies only to those who began or changed coverage, you can ignore it and likely go onto something else more enjoyable.

If you had consistent HSA eligible insurance for each month of the year, the Last Month Rule does not apply and you can put “0” on Line 18 of Form 8889.

On the other hand, if you began or changed HSA coverage this year, let’s pose three “yes” or “no” questions to help determine if the Last Month Rule applies to you. You must answer “yes” to the following 3 questions to be eligible to use the Last Month Rule. Answering “no” to any of the following means you can only contribute the pro-rata contribution amount for the months you were HSA eligible.

1) Were you an eligible individual (have HSA eligible coverage) on December 1st of the tax year?

Answering “no” precludes you from using the Last Month Rule as it is a base requirement. This rules out people who, for example, had coverage from January – November of a year, or had coverage from February until August of a tax year. You at least have to have coverage in December to be eligible for the Last Month Rule.

If you answered “yes”, then you may be eligible to use the Last Month Rule, read on.

2) You were HSA eligible (had HSA coverage) for only part of the year?

Answering “no” means you had coverage for the full year, so by definition you can already contribute the HSA maximum contribution limit. You had coverage for 12 months, so can contribute 12/12 or 100% of the contribution limit for the year. You don’t need the Last Month Rule’s help. If this applies to you, put “0” on line 18 of Form 8889.

If you answered “yes”, you likely began coverage mid-year. Perhaps you got a new job and had HSA qualified starting on April 1st, so 9/12 months of the year. Or you had coverage for January through April, then stopped, then had coverage for November and December. If this sounds like your situation, this means that you have the option of using the Last Month Rule for that year. To actually use it, move on to question #3.

3) Did you contribute more than you would otherwise be allowed?

Answering “no” means you contributed less than or equal to your contribution limit based on your months as an eligible individual. So if you had HSA coverage for 5 months, you are allowed to contribute up to 5/12 (41.6%) of the contribution limit without using the Last Month Rule. Doing so plays it safe and avoids any of the requirements or risk of penalty associated with the Testing Period.

Answering “yes” sounds like, “I had HSA coverage for 7/12 months but I contributed the maximum contribution limit using the Last Month Rule”, or “I had coverage for 3/12 months (Oct / Nov / Dec or 25%) but contributed 1/2 (50%) of the maximum contribution limit.” In both of these scenarios, you contributed more to your HSA than you would generally be allowed. This is allowable, as you leveraged the Last Month Rule to make an increased contribution, but remember it has strings attached.

Conclusion

If you answered “No” to any of the 3 questions above, you cannot use the Last Month Rule. You will need to contribute your pro-rata contribution limit based on the number of months you were HSA eligible. You can also put “0” on Line 18 of Form 8889.

If you answered “Yes” to all 3 questions above, you used the Last Month Rule and contributed more than you generally could have. This is allowable but remember you need to maintain HSA coverage for the next year due to the Testing Period. For the current year, you can put 0 on Line 18. If you maintain that HSA coverage through the following year, you will also put “0” on Line 18 of that year’s Form 8889, pass the Testing Period, and hopefully never worry about the Last Month Rule again. Only if you don’t maintain coverage (i.e. fail the Testing Period) will you need to calculate a penalty for Line 18, which will increase your taxable income and add a penalty to your 1040 return.

Note: if this is super confusing, please consider using my service EasyForm8889.com to complete Form 8889. It asks these questions in a straightforward way and will generate your HSA tax forms in 10 minutes. It is fast and painless, no matter how complicated your HSA situation.

How to Make a Non Qualified Withdrawal from your HSA

This question was submitted by HSA Edge reader Felicia. Feel free to submit your question today to evan@hsaedge.com.

I would like to withdraw money from my HSA as a non qualified withdrawal. How do I do this?

Doing a non qualified withdrawal from an HSA is dangerously simple – all you have to do is take the money out. There are no forms during the distribution that declare whether it is qualified or not. Instead, this will be settled at tax time when you file Form 8889. It will ask how much money was withdrawn from your HSA, and how much of that was used to pay for qualified medical expenses. The difference is taxed and penalized as a taxable (non qualified) HSA distribution.

Here is an example of a non qualified withdrawal for 2016 created by EasyForm8889.com:

form-8889-non-qualified-withdrawal

In your case as in the above example, the amount withdrawn and the amount spent on qualified medical expenses do not equal. Thus, those are non qualified distributions and that amount is added to income and penalized. However, paying taxes and penalty may be worth it to get access to the funds.

There are some exceptions to paying the penalty – namely reaching age 65, becoming disabled, or dying – but those don’t often apply.

Of course, I would advise that you try to get this money out penalty free, so recommend my article Can You Cash Out An HSA. There are a few methods you can use to get funds out, but most involve incurring some sort of medical expense to disburse the funds. However, thinking creatively can help bridge this gap. For example, are there things you are spending money on that are actually qualified medical expenses? Or, are there any qualified medical expenses in your near future (e.g. glasses, doctor’s visits, procedures) that you can pull forward to at least get access to the HSA funds?

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Note: If you need to account for non-qualified withdrawals on Form 8889, please consider my service EasyForm8889.com. It asks you simple questions and fills out Form 8889 correctly for you in about 10 minutes.

How to Handle Excess Contributions on HSA Tax Form 8889

Overview

Excess Contributions occur when you contribute more to your HSA than you were allowed. This compares your contribution limit for the year (which can vary on many factors) and the actual amount of money that came into your HSA, including such things as Employer Contributions, Qualified Funding Distributions, and Prior Year Contributions. That being said, if you find yourself in a situation facing Excess Contributions, you may find it a challenge come tax time when you are faced with Form 8889. Fear not, as this article will guide you through how to avoid taxes and penalties and get this IRS required tax form filed.

Include the Excess Amount in Contributions

Part I of Form 8889 is appropriately called “Contributions”. It details amounts contributed to your HSA, your contribution limit, and calculates the deductible amount that flows over to Form 1040. It will feel strange, but you want to include all amounts contributed to your HSA, even if they are in excess. Doing so accurately reflects the account activity, so that when your HSA custodian provides Form 5498-SA to the IRS, the amount contributed will match your Form 8889. Remember, there is no taxes and penalty for having excess contributions in your HSA, if you remove them (and any earnings) before your tax filing deadline. The point is it is OK to show excess contributions in the contribution section of Form 8889, the key is that you have to proactively take care of them.

Example: Excess Contributions on Form 8889 Part I – Contributions

In this example we contributed $4,850 (contribution, employer contribution, and funding distribution) to our HSA. However, our contribution limit was only $3350, leading to an excess contribution of $1,500. The key is that we have included all contributions that caused the excess contributions and lived to tell the tale.

An example of 2016 Form 8889 prepared by EasyForm8889.com

HSA_excess_contribution_form_8889_1

Notice the warning at the bottom that states:

“Caution: If line 2 is more than line 13, you may have to pay an additional tax (see instructions).

Our Line 2 ($4,350) is indeed greater than Line 13 ($2,850), so we are at risk of paying excess tax. However, per the instructions, if we remove the excess contribution and any earnings on it before the tax deadline, we owe no taxes or penalty:

HSA_Excess_Contribution_instructions

To rectify this scenario, we would need to log into our Health Savings Account and request a distribution that specifically states it is a removal of an excess contribution for 2016 (see next section). You must specify this so that they don’t code it as a regular distribution for qualified medical expenses. In the above example this would be for $1,500 coming back out of the HSA. We will account for that removal in the next section.

Include the Excess Amount in Distributions

Part II of Form 8889 is called “Distributions” and details money that came out of your HSA. Similar to the logic stated in Part I, we need to be transparent about the excess contribution to avoid the ire of the IRS (and taxes and penalty). We will do this by 1) counting the removed excess contribution as a distribution and 2) calling it out as a distribution due to excess contribution. Again, you need to remove excess contributions (and any earnings) from your HSA before the tax filing deadline, and doing so creates a distribution from your HSA.

To actually remove the excess contribution, you need to go to the website of your HSA custodian and create a distribution for the excess contribution. When you do this (important), there should be a box stating “I am removing an excess contribution from my HSA”. This differentiates the distribution from one being used for qualified medical expenses, and informs your HSA custodian how to code the distribution on Form 1099-SA. If you correct the excess contribution before tax year end, this distribution will be reported on that year’s Form 1099-SA. If you do this in the following year (say, Jan-April 15th, before tax day), your HSA custodian may or may not send you a 1099-SA for the distribution before tax day. If they don’t, you need to keep that distribution of excess contributions in mind for filing taxes.

Example: Excess Contributions on Form 8889 Part II – Distributions

Reporting this activity on Form 8889 is relatively easy, as there is a mechanism in Line 14 that handles excess contributions for us. Back to our example of a $1,500 excess contribution that was removed, our Form 8889 ends up looking like this:

An example of 2016 Form 8889 prepared by EasyForm8889.com

HSA_excess_contribution_form_8889_2

Line 14 has 3 parts that we use to detail our distributions. We include the excess contributions removed in this total amount, and call out the amounts that were removed due to excess in 14b. The breakdown of line 14 is below:

Line 14a – The total amount of distributions for the year, including those for excess contributions and their earnings
Line 14b – Distributions that were for excess contributions and their earnings
Line 14c – A calculation of distributions that should have been spent on qualified medical expenses

As you can see, excess contributions avoid taxes here because they are excluded from Line 14c. If any amounts in 14c are not spent on qualified medical expenses, they are taxed and penalized. We stated that $300 that we normally distributed was spent on qualified medical expenses, by tracking our receipts in a tool like TrackHSA.com. The takeaway from the above logic is that the IRS does not expect you to spend excess contributions on QME, and does not tax or penalize you on these distributions if they are handled properly.

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Note: if you want step by step instructions for your Excess Contributions on Form 8899, or just want to get it right the first time, please consider using my service EasyForm8889.com to complete Form 8889. It is fast and painless, no matter how complicated your HSA situation may be.