I have both an FSA and HSA. How can I fix this mistake?

Question

Expecting a lot of medical expenses in 2017, I signed up for both the medical FSA and HSA offered by my employer. Unfortunately, my employer did not mention that it was against the rules to have both.

When I discovered my error 11 months later, I asked my employer if I could back out of the FSA. They said this was not possible. They said that the only thing they could do is stop my automatic HSA payroll deduction.

So I need to undo the HSA somehow. Reading other similar answers it sounds like I should withdraw the remaining HSA balance as an overpayment.

This makes sense to me, but there is one other complication: my employer contributed $1000 to the HSA.

Here is my plan, but I'm not sure if it right.

1. Withdraw all HSA funds as an overpayment.
2. When I do my taxes, make sure there is no deduction made for HSA contributions.
3. Count the $1000 as other income, paying taxes on it.

Answer 1

One snag in your plan is that you alone can't undo your HSA contributions because you would also owe FICA taxes on that amount, and those need to be paid by both you and your employer. The only way for that to happen is for your employer to undo your HSA contributions from their point of view so those wages can be entirely taxed with both FICA and regular withholding. How that is accomplished will probably be up to them. It could mean you pulling the money out of the HSA account, and then either giving it back to your employer so they can re-allocate it with a new check, or, if you have enough pay due between now and the end of the year you could keep the money and they can reduce your next paycheck(s) by the total additional taxes due. Note that you should prefer the latter if possible, since this way you would get to keep the $1000 you shouldn't have gotten in the first place.

Also, note that when you withdraw the money from your HSA account you need to inform your bank that you are undoing the contributions rather than taking distributions (and likely fill out a form). If you don't inform them they will improperly report to the IRS that you had contributions and an equal amount of distributions, which could muddy the waters with also having an FSA.