Can an HSA excess contribution withdrawal be done when you haven’t really contributed an excess?

Question

If you find that you have contributed more to your HSA than your annual contribution limit, you can do an excess contribution withdrawal. This is effectively an “undo” button on your contribution: On your tax return you only report the amount you contributed without the excess. Any investment gains that were earned in the HSA using those excess funds must also be withdrawn, and they are added into your taxable income, so you can’t gain anything by contributing too much at the beginning of the year and withdrawing it at the end of the year.

Here’s my question: Let’s say someone made an HSA contribution and then later changed their mind in the same year. Can you do an excess contribution withdrawal even if you haven’t contributed past your limit? Would the IRS have a problem if it was reported to them that an excess contribution withdrawal was done, yet you didn’t report on your return that you had contributed up to your limit?

I have looked at IRS Pub 969 and I couldn’t find anything that explicitly prohibits this.

I don’t think the bank would have a problem with it, because they have no way of knowing what your contribution limit is. (It can be prorated based on your health coverage over the year.) But the IRS would know since you enter your prorated limit on Form 8889.

I am not in this situation, but if this is allowed it could help the OP of another question.

Answer 1

No, you cannot simply withdraw (non-excess) HSA contributions, you will owe a 20% fee (in addition to the due taxes); It doesn't matter if it is the same year.

Source: IRS (Notice 2004-50 Q&A 35)

Q-35. May an individual who has not made excess HSA contributions treat a distribution from an HSA other than for qualified medical expenses as the withdrawal of excess HSA contributions?

A-35. No. This withdrawal is deemed a withdrawal for non-qualified medical expenses and includable in the individual’s gross income under section 223(f)(2). (The additional tax under section 223(f)(4) also applies, unless otherwise excepted).

The only exceptions for the 20% fee are when you turn 65, become disabled, or die.

Answer 2

HSA withdrawals are done on a direct charge basis (from a medical provider or similar), or on the basis of a self-reported reimbursement taken after the event. In this second case, the impetus remains on the individual to retain all documentation of expenses for several years after the fact. This is so that in the event of an audit, you can show a paper trail for each private withdrawal that you have made.

So what is the paper trail for withdrawals which are done as a refund of contributions? HSA by nature is a pre-tax account, with income tax not applying under normal use cases. By 'undoing' a contribution, you are in essence saying to the government "This income should have been taxed normally" and you need to report it appropriately for tax purposes.

This is done using form 8889 (standard form for HSA qualified and non-qualified distributions), and also by placing the income on line 21 of Form 1040, with the text "HSA" as the explanation. NOTE: In most cases there is an additional 20% tax on non-qualified distributions, see the instructions for form 8889 for more details.

Answer 3

I'll preface this by saying I'm not necessarily a trust or IRS definition expert, but here goes. But I think this is a great question so it was fun to go looking through the regulations anyway.

To start I think this is the sentence in the IRS regs that really applies to this situation:

(E) The interest of an individual in the balance in his account is nonforfeitable.

This sentence is from US Code 26 Section 233(d) regarding Health Savings accounts. In broad strokes the IRS says contributions made to the trust created to house the HSA cannot be returned no matter who made the contribution. I tried looking for something that specifically said the contributions to the trust are irrevocable as the revocable/irrevocable differentiation of trusts is typically highlighted pretty obviously but couldn't find that specific word. I think the sentence above is essentially the irrevocable sentence.

The IRS HSA Trust Agreement October 2016 Revision (this is the most recent revision I could find) also includes the "nonforfeitable" language.

A Health Savings Account is defined as "a trust created or organized in the US as a health savings account exclusively for the putpose of paying qualified medical expenses of the account beneficiary"

The regulations then go on to define the five criteria that must be met in order for an HSA contribution to be valid:

1. Except for rollovers no contribution can be accepted unless it is cash, and does not exceed the annual maximums stipulated by the IRS

2. The trustee is a bank, an insurance company or other sufficiently approved administrator.

3. Trust assets can not be invested in life insurance

4. Trust assets will not be commingled with other property

5. The interest of an individual in the balance in his account is nonforefeitable.

The regulations then go on to define qualified medical expenses, who the account beneficiary is, and so on and so forth. It seems the pertinent bit is that in order for a contribution to an HSA to be deemed valid it is permanent but for excess contributions because that breaks rule 1 above.

I looked for, but unfortunately couldn't find, a copy of the agreement I signed when I established my HSA to see if it used the word irrevocable. I'm pretty comfortable concluding "excess" contributions are a different than optionally rescinding or reversing a contribution.