Penalty | HSA Edge

Overview

The IRS defines a maximum amount that you can contribute to your Health Savings Account each year, appropriately called the HSA Contribution Limit. This amount varies each year (adjusted for inflation) and is impacted by your age, type of insurance, and length of coverage during the year (see: 2017 HSA Contribution Limits). You cannot legally contribute more than the HSA Contribution Limit, but what if you accidentally do? These are called Excess Contributions and they can lead to penalties, paperwork, and headache. We will show you how to remove or apply personal and employer excess contributions and avoid penalty.

What are HSA Excess Contributions?

By definition, an excess contribution results when you over contribute to your HSA for the year. But what is over contribute? The first step is defining your contribution limit for the year. The IRS defines HSA contribution limits by type of insurance coverage: Self-only or Family. For 2017, these amounts are $3,400 and $6,750, respectively. You can also contribute $1,000 more if you are over 55 per the Catch-Up Contribution. These totals assume full year coverage, and your contribution limit is reduced proportionately for partial year coverage.

Once you know how much you can legally contribute, the second step is determining the amount you actually contributed to your HSA. While this sounds simple, there are multiple sources to consider here. When calculating excess contributions, the IRS defines your HSA contributions as:

Amounts contributed for the year include contributions by you, your employer, and any other person. They also include any qualified HSA funding distribution made to your HSA. Any excess contribution remaining at the end of a tax year is subject to the excise tax.

If your HSA contributions exceed your contribution limit, you have an excess contribution. Knowing this value will be key for rectifying the discrepancy.

Why This Happens

There are a few common scenarios that result in Excess Contributions, given the various factors that determine your contribution limit on Form 8889. Here are the most common situations that can lead you to over contributing:

Too many contributions – This is just a simple technical issue of too much money going into your account, likely due to a math error or unexpected contribution. For example, if your contribution limit was $3,400, and each month you contributed $300 to your HSA, you would contribute $3,600 for the year. This leaves $200 in excess that needs to be removed.
Employer contributions – A similar scenario occurs with employer contributions to an HSA. Granted you are quite lucky but perhaps it is unclear how much they will contribute. Or your employer contributes a variable amount based on some factor. Either way, employer contributions count toward your maximum HSA contribution so these must be included in a calculation of Excess Contributions.
Miscalculated your contribution limit – This is the most subtle (and painful) way to over contribute. In this example, you assumed you were allowed to contribute $3,400 to your HSA this year, which you did. You find out that you were only an eligible individual for 10 months, so your contribution limit is really 10/12ths of your max contribution limit. Or, you front loaded your HSA contributions early in the year and then lost HSA eligible insurance. In either case, there is too much in your HSA for the year and you need to remove it.

Excise Tax

The government imposes penalties if you over contribute to your HSA. Per the IRS guidelines:

Generally, you must pay a 6% excise tax on excess contributions. See Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts, to figure the excise tax. The excise tax applies to each tax year the excess contribution remains in the account.

So a few important points here. The penalty rate is 6% on the amount of calculated excess contributions. Not sure how 6% was determined but it is very close to an expected rate of return in the market. Either way, the kicker is you must pay this penalty each year the excess contributions remain in your account. So this is the gift that keeps on giving and you must rectify anything over contributed to avoid tax and penalty.

How to Correct Excess Contributions

Luckily, the IRS is lenient on fixing excess HSA contributions. They provide two options of correction: removal or future application. The first removes the HSA contributions in the tax year and avoids a penalty – no harm, no foul. The second “let’s them ride” in the account where they can be applied to a future year’s contribution, but incurs a penalty each year. We will walk through both scenarios below.

Option 1: Remove in the Current Year

This is probably the preferred option. If you catch your mistake before you file your taxes, you can avoid all penalties by removing the excess contributions (and any of their earnings) from your HSA and treating them as normal taxable income. Per the IRS:

You may withdraw some or all of the excess contributions and not pay the excise tax on the amount withdrawn if you meet the following conditions.
1) You withdraw the excess contributions by the due date, including extensions, of your tax return for the year the contributions were made.
2) You withdraw any income earned on the withdrawn contributions and include the earnings in “Other income” on your tax return for the year you withdraw the contributions and earnings.

The IRS spells it out pretty clearly there, but the removal of the excess contributions and the earnings on those excess contributions must occur before your tax due date. The removed is taxable since HSA tax benefits do not apply. Earnings on excess contributions occur if your HSA is invested or earning interest. Removing those seems fair, since those investments shouldn’t have been made in the first place. The IRS solves all of this by saying just remove them, don’t deduct (i.e. pay tax on ) the excess amounts, and declare any earnings as other income. Could be worse.

Since dollars in your HSA are fungible, it is very difficult to determine exactly which investment they were put into and from where they should be removed. This makes it difficult to determine the exact earnings for the dollars specifically declared excess contributions. Thus, the IRS permits an “average” determination of the gains of the HSA during that time, and the pro rata share of those average gains that can be attributed to excess contributions.

Forms for Removing Excess Contributions

You will need to specifically inform your HSA trustee of a correction and that you wish to remove an excess contribution to your HSA. This triggers them to classify the transaction separately, as opposed to a normal withdrawal for qualified medical expenses. They will proceed to file an additional Form 1099-SA showing the excess contribution being distributed from the HSA with a distribution code of “2”. Be sure to remove and identify any earnings on the excess contribution as well. This form will be provided to you to indicate 1) a distribution from the account that 2) was for excess contributions. The form will look something like this:

hsa-form-1099-sa-completed-excess-contribution-for-2016

The other thing that should occur is your HSA trustee will correct your Form 5498-SA which shows HSA contributions for the year. While they initially would have included your excess contribution (they didn’t know it was excess), once you alert them and withdraw it, they will remove it from Form 5498-SA. That means that your Form 5498-SA will be accurate for the year and should not include any excess contributions.

Option 2: Apply to a Future Year

Alternatively, you can use an excess contribution as your HSA contribution in a future year. You just let your excess contribution sit and then apply it later; the downside is there is a 6% per year penalty. The mechanism that allows this is the deduction, since next year you won’t actually deposit the contribution (it is already there), you will just deduct it on Form 8889. As an example, if you have excess contributions in 2016, you can let them sit there until 2017 and then use them as your contribution for 2017. Rolling an excess contribution to a future year is allowed per the IRS Form 969:

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

So the IRS allows you to roll forward excess contributions and not remove them, but apply them to future periods. You can’t apply more than you have in excess and you can’t apply more than that year’s HSA contribution limit. The downside to this plan is that you must pay the 6% excise tax on the excess contribution for each year it remains in your account as excess (i.e. not applied).

Removal Deadline

To avoid penalty, you must remove excess HSA contributions in the year that they occur. This must be done before your tax filing deadline. Note that this includes extensions, so filing an extension on your taxes increases the amount of time you have to remove the excess. If you elect to apply the over contribution to a subsequent tax year’s HSA, the deadline is the same. While you will eat the 6% penalty the first year, you have until you file your taxes to declare the excess a contribution and deduct it from your taxes.

Excess Employer Contributions to an HSA

While employer contributions are normally a great thing, they can cause some pain should they become excessive (hah!). Since employer contributions to your Health Savings Account count toward your yearly contribution limit, you must factor them into your limit. Three situations can arise from employer contributions:

Employer and Employee over contribute – If both you and your employer contribute to your HSA, the onus is on you to not over contribute. Thus any over contribution is from the employee and the employer cannot claw back their contribution (see next section).
Employer alone over contributes – In this case, the employer can file to have the contributions (and earnings) returned by December 31st. If they fail to do this, the excess amounts will be filed as income on the W-2 and the excess will need to be removed by the employee.
Employer contributes to ineligible individual – The unlikely event that an employee is not eligible but receives HSA contributions functions much like the above example. If it is caught by December 31st, it can be recovered, but after that it becomes wages and the monies do not function as an HSA (just a regular account).

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Two confusing concepts for Health Savings Accounts are the Last Month Rule and the Testing Period. Both of these help determine your contribution limit to your HSA during the year you first sign up for health insurance as an eligible individual. (Note: If you are filing HSA tax Form 8889 and are on Line 18 that says “Last Month Rule”, this only needs to be filled out if you failed the testing period and owe a penalty; read on. Otherwise, it is $0

I have created the following video to explain the Last Month Rule and Testing Period. Check it out, otherwise, the transcription of the information is below.

Watch on Youtube: HSA Last Month Rule and Testing Period

The Last Month Rule

The Last Month Rule states that if you are covered by an HSA eligible health plan on the first day of the last month of a given year, you are considered an eligible individual for the entire year. This gives you the option to contribute the entire year’s contribution limit to your HSA, which is more than you would be allowed otherwise (pro rata by month).

If you are covered by an HSA eligible health plan on 12/1 of a given year, you can contribute (and deduct) the full year’s contribution limit.

For example, you could begin HSA coverage in November of a given year. Come December 1st, you are covered and per the Last Month Rule, are considered an eligible employee for that full year. That allows you to contribute up to that year’s contribution limit, if you want, even waiting a few months to make a prior year contribution. Back up the truck and load up the HSA!

However, the Last Month Rule is a powerful tool that does bear risk and further responsibility.

The Testing Period

The Testing Period states that if you use the Last Month Rule, you must remain an eligible individual (covered by HDHP) for the next 12 months, so through December 1st of the following year. If you fail to remain an eligible individual (change insurance plans, lose insurance plan, receive other health coverage) during that time, any “excess” contributions you made as a result of using the Last Month Rule will be taxed and penalized.

If you contribute per the Last Month Rule and end your HDHP insurance before the Testing Period ends, excess contributions will be taxed and incur a 10% penalty.

In this case, “excess” contribution are amounts you contributed in violation of the Testing Period. Said another way, you contributed more based on the Last Month Rule, and the Testing Period required you to maintain HSA eligible insurance for one year. You did not fulfill this year, and you will have to subsequently recalculate what your contribution limit would have been and pay taxes / penalty on the difference. You can see this on the Form 8889 Instructions in Section 3, Line 18.

Calculating Last Month Rule Penalty

Using the Form 8889 Instructions, use the Line 3 Limitation Chart and Worksheet to calculate what your actual contribution limit was for the prior year, not using the Last Month Rule. For example, if you started HSA eligible insurance on August 1st, you would fill out (yearly) contribution limits for August, September, October, November, and December, then divide by 12. This number ($1396), your allowable contribution limit, will be compared to the contributions you made via the Last Month Rule.

Line 3 HSA Last Month Rule

Likely, you previously contributed more than you were allowed. The difference is your excess contribution resulting from failing the Testing Period, and this line will be entered on Line 18 of Form 8889. This excess contribution amount invokes a penalty for violating the last month rule in both 1) tax (your marginal tax rate, say 25%) + 2) penalty (10%). This flows through back to your taxes by 1) adding back this income to your taxable income and 2) assessing an additional penalty in Section 3 of Form 8889.

Testing Period Examples

Here are some examples to demonstrate how the Testing Period works:

Example 1 – no problem
Paul is covered by an HSA family insurance on December 1st. He is able to take advantage of the Last Month Rule and does, contributing the maximum to his HSA for that year even though he only had coverage for one month. He does not change plans for many years so passes the Testing Period, which lasted until 12/1 of the following year.

Contribution made = $6,650
Allowable contribution = $6,650 (fulfilled Testing Period)
Excess Contribution = $0

Example 2 – coverage type problem
George was covered by single HSA coverage from January – November, but on December 1st changed to family plan HSA coverage. Using the Last Month Rule, he contributed the full family amount for the year ($6,650) to his HSA. However, he ended his HSA eligible insurance in November of the following year, meaning he failed the Testing Period at its end on the following December 1st.

Contribution made = $6,650
Allowable contribution = $3,625 (11 months single; 1 month family)
Excess Contribution = $3,025
Taxes due = $756 ($3,025 x 0.25 tax rate)
Penalty = $303 ($3,025 x 0.1 penalty rate)

Example 3 – ending coverage problem
John is covered by a single HSA eligible insurance plan on December 1st. He is able to take advantage of the Last Month Rule and does, contributing the maximum to his HSA for that year even though he only had coverage for one month. He continues making monthly average contributions (contribution limit / 12) for 6 months until June 30th, when he switches jobs and no longer has HSA insurance. As a result, he is no longer an eligible individual during his Testing Period. He has made 18 monthly average contributions during 7 eligible months, so he now needs to declare 11 of those as income during the year and pay a 10% tax on that amount. His calculations are:

Contribution made = $3,350
Allowable contribution = $279 ($3,350 * 1/12)
Excess Contribution = $3,071
Taxes due = $768 ($3,071 x 0.25 tax rate)
Penalty = $307 ($3,071 x 0.1 penalty rate)

Effects of the Last Month Rule / Testing Period

In the above examples, the account holders were taking a calculated risk that they could satisfy the Testing Period of the following year. You can see the tax/penalty is substantial for failing it. Thus, while powerful, the Last Month Rule can be a double edged sword. Some effects are:

+ Can make full year contributions during years of partial coverage
+ Jump start contributions to your HSA
+ Can reduce your taxes in the year you sign up for an HSA
– Risk over contributing and invoking taxation + 10% penalty

Determine your risk

When making a decision about a Last Month Rule situation, consider the following which may negatively affect you during the Testing Period :

How likely are you to change jobs during the Testing Period? Will your future employer offer HSA plans
How likely are you to change plans during the year, do to changes in status or partner’s plan?
How likely is your employer to change your health insurance options during the Testing Period?

Perhaps the safest strategy is waiting until the following year (but prior to April 15th) to make a Prior Year Contribution. This ensures you do not over contribute during a period and have to declare and pay tax on an amount. The strategy here is to save monthly amounts in a non-HSA account, and after the fiscal year (but before April 15th), contribute the money to your HSA as a prior year contribution.