HSA over-contribution if I lose my job part way through the year

Question

My employer provides my health insurance as part of my compensation and benefits package. It is a qualifying HDHP and as such every year I generally max out my HSA, either through payroll deductions or direct contributions by bank transfer.

I have an expensive surgery scheduled early next year (February) and so want to contribute my full HSA allowance to my HSA in the first couple of months of the year, which would allow me to pay for the surgery in full from my HSA. My employer allows this and it would be a convenient way to pay for the surgery - I do not expect any other medical expenses for the rest of the year as the surgery will max my plan out of pocket.

However my concern is that if I do this and end up losing my job, either for unrelated reasons or because they are unwilling to retain me while recovering from the surgery (2-3 months of recovery) I will be in a tough situation, I will have to get new insurance which may not be an HDHP which would mean my contribution was too high. I do not think it is likely this will happen but I want to prepare for this situation if it does.

If this does indeed happen, what will my tax position be? Can I retroactively pay tax on the HSA deposits which turned out to be ineligible or will I end up with some huge penalty for having contributed when not allowed? Ultimately I want to know what the worst consequences of this situation would be and what I would be able to do to mitigate them as much as possible?

Answer 1

Contribution limits are pro-rated if you aren't eligible for the entire year. Suppose you lose your HSA eligibility in May of next year. Your HSA contribution limit would be 5/12 of your contribution limit for 2020. If you have already contributed the full amount you can reverse the excess contribution by filling out a form with your HSA administrator. Note you have until you file your taxes the next year to do this (which would be about April 15, 2021), so you don't have to fix it right away when you lose your eligibility. Besides, you may still get another job or insurance another way that is HSA eligible, and you wouldn't know that this won't happen until the end of the year.

But continuing with the example, if the end of the year comes and you didn't obtain new HSA eligible insurance, you would need to reverse 7 months of excess contributions. If you also distributed the full amount you would have to first reverse the excess distributions, and then reverse the excess contribution. It's possible that your HSA administrator would be able to do this virtually for you without any changing of funds, since they would essentially be re-characterizing 7 months of distributions as a refund of excess contributions. But if they can't do it virtually, you would have to actually give them the money back to undo the distribution, and they would give the money back to you again to undo the contribution. Either way, it can be done without any penalties as long as you do it before you file your taxes in the next year.

By the way, another thing you could do to avoid the hassle is just pay for the surgery out of pocket, and then at the end of the year make the contribution and distribution right afterwards for the amount you are eligible for. This way you don't run the risk of having to reverse anything. However, you would need to have enough cash on hand to be able to do it, and you'd possibly lose the ability to reduce your payroll taxes with the end-of-year HSA contribution if you lost your job.