Is interest “earned” in an HSA even without taking any distributions?

Question

I live in California. During 2019 I contributed to a Health Savings Account; I didn’t take any distributions. I’m reading the 2018 instructions for Schedule CA—the 2019 instructions don’t seem to be online yet—and they say,

Enter in column C the interest you identified as tax-exempt interest on your federal Form 1040, line 2a, and which you received from […] Interest or other earnings earned from a Health Savings Account (HSA) are not treated as taxed [sic] deferred. Interest or earnings in a HSA are taxable in the year earned.

The HSA includes a “cash” component, which earned interest in 2019, and a mutual-fund component, which gained value through dividends and market gains. Are all three of these types of gains taxable in California even though I didn’t realize them by taking money out of the account?

Answer 1

I believe the answer is Yes. Basically, California doesn't recognize HSAs, and taxes it like a regular non-privileged account. So you must apply whatever adjustments to the federal amounts so the end result for California is what it would be if it were a regular taxable account.

So for example, contributions to the HSA (either through the employer or yourself separately) are after-tax, so you apply an adjustment to either wages (in case of contribution through employer) or to the HSA deduction (in case of contribution yourself) to cancel out the deduction. And when you withdraw for non-medical expenses, it's taxable for federal but not for California since it's a regular taxable account so you adjust away the tax (and penalty if applicable).

Similarly, for gains inside the HSA, it's not taxed for federal but you must adjust it for California so that it works like a regular taxable account. So for interest earnings you must add an interest adjustment. For dividend earnings, you make a dividend adjustment. For capital gains, you make a capital gains adjustment, but only when you sell it, just like how you only pay taxes on capital gains on a regular investment account when you sell it. If an investment asset's value went up but you didn't sell it, you don't report it.