What if an employer sets up and contributes to an HSA for an ineligible employee - can he withdraw the excess contributions with no penalty?

Question

My son is 21 years old and starting his first job. He is covered under my health insurance, which is a non-HDHP PPO, until he turns 26. (Because I have other children, I wouldn't save any money by no longer including him in my family plan.)

His new employer offers a HDHP with no monthly cost to the employee, and they contribute $100/month to a HSA for each employee. The plan has a $1500 deductible.

It's a no brainer to take the insurance, since it's free to him, and may cover some things better than mine does. We've spoken to the coordination of coverage person at my health insurance company, and it looks like the combination of the two plans will be very favorable for him.

But my understanding was that because he has "other insurance" (mine) which is not a HDHP, he is not eligible to have a HSA. He asked if the employer could put the money into a FSA for him instead, but they said that they could not. We did some calculations, and we believe that having my coverage as secondary coverage will save him more than $100/month right now, so he decided to take the HDHP (which will be his new primary insurance), keep my PPO also as secondary, and forego the HSA contribution.

Today they told him that the person who handles their benefits thinks he is still eligible for a HSA. He has been clear with them that he is covered by another health insurance plan which is not a HDHP. If they set up an HSA for him and they're wrong about his eligibility, what will the consequences be, to them and to my son?

It looks like he will have to pay additional taxes on the money, however, since it's free money, that's not a big problem. Since he's not eligible for a HSA, his eligible contribution maximum is $0. If his employer contributes $1200 for him (but he contributes no additional funds of his own) he'll have excess contributions of $1200.

It looks like on Form 8889 he'll declare the $1200, add it to his taxable income, and pay 10% additional tax on it. It seems like he may also have to file form 5329 and pay 6% excise tax on it.

The part I don't understand is that he has an option to withdraw the excess contributions and avoid some of those penalties. In that case, does he not need to spend the money on qualified medical expenses? Can his employer just put $100 each month in the account for him and he just immediately withdraw it? In that case I assume he still needs to file form 8889 and count it as income, but does he avoid both the 10% and 6% tax penalties by doing that?

To me it makes sense that if he accidentally put his own money in when he wasn't supposed to, he could just take it out and pay the tax on it and be fine. It's when it's his employer putting the money in for him that it seems more confusing to me. Can he just take the money out and it doesn't count as a "distribution" that needs to be used for qualified healthcare expenses? Is there any benefit to actually spending the money of qualified healthcare expenses?

Is it OK for him to use the HSA for which he is ineligible as a pass-through of taxable income from his employer, which he will immediately withdraw as an excess contribution correction?

Update: His employer has just realized that he is in fact not eligible for an HSA. Or at least in their understanding he can have an HSA but neither he nor they can contribute to it. Obviously he'd like to get the free money if he can, even if he has to pay taxes on it. Is there any penalty to his employer if they contribute to an HSA on his behalf, knowing that he is not eligible, and that the money will be an excess contribution?

Answer 1

They're wrong. The IRS instructions (pub 969) specifically say:

To be an eligible individual and qualify for an HSA ... You [must] have no other health coverage except what is permitted under Other health coverage, later.

So no, he is not eligible for HSA if he keeps your coverage.

Here's what the same IRS Publication 969 has to say about the excess contributions (contributions in excess of what is allowed):

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.

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.

• You withdraw the excess contributions by the due date, including extensions, of your tax return for the year the contributions were made.

• 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 6% excise tax is on top of any other tax (like the regular income tax) that he has to pay on the money.

Answer 2

A few thoughts:

You said,

To me it makes sense that if he accidentally put his own money in when he wasn't supposed to, he could just take it out and pay the tax on it and be fine.

In this case, he would be putting his own after-tax money in, and wouldn't be able to deduct it, so the act of putting it in and taking it back out in the same tax year would be as if the transaction never occurred at all. He would not have to "pay the tax on it".

As for this question:

Is there any penalty to his employer if they contribute to an HSA on his behalf, knowing that he is not eligible, and that the money will be an excess contribution?

It's good that your son is prepared to treat it as regular income and pay the appropriate taxes. However, the employer should be the one doing that. They should be treating it as regular income and taking out FICA and paying their end of FICA too. If they aren't doing that, technically they are breaking the law.

The employer really shouldn't be making the contributions at all, and if they ever bothered to correct this, this article suggests that the employer may be legally allowed to drain the HSA account and take their money back out of it, but only for the same tax year. Apparently they can do this without your son's consent. If that's true, it may make sense to withdraw all money from that account immediately as soon as the money arrives, since they cannot take the money back if it is no longer there. Once the money leaves the HSA account the employer has no choice but to change it to income and if they don't, your son must declare it as such (which it sounds like he is prepared to do). This doesn't really answer your question of whether or not the employer can be penalized- I would assume yes, but not too badly. The worst case scenario for them would probably be just having to pay all the back FICA on those funds if they aren't doing so already. Maybe an interest penalty as well.

All that being said, I'd recommend talking to an accountant. The most important thing you want to be sure of is that your son cannot possibly be liable for any wrongdoing. Particularly I would get confirmation on pulling money out of the HSA that you know shouldn't be there in the first place, just to make sure there is no possible way to get dinged for that.