Understanding what the penalties are for and what your options are for correcting a mistake can help you avoid the fees when tax season comes around.
1. Contributing over your limit, otherwise eligible: 6% Excise Tax
- Part I of the IRS Form 8889 determines your yearly HSA contribution limit. Your limit is determined by your coverage type, age, and eligibility by month. To be eligible, you must be covered by only HDHP insurance and not on any form of Medicare, starting the first day of the month. If you contribute over your yearly limit, you are charged a 6% excise tax on the amount over your limit every year until you fix it.
- You have through the tax deadline to fix an over-contribution and avoid the 6% tax. Contact your bank and ask to do an “excess contribution correction.” They will return the money to you in the amount over your limit, and you will count this as additional income for the year and pay only the income tax (but not the penalty) on the amount.
2. Contributing when you failed to remain eligible during the testing period: 10% fine + applicable income tax
- Part III of IRS Form 8889 deals with whether or not you maintain eligibility during the testing period. The testing period can apply to two scenarios: the Last Month Rule and a qualified HSA funding distribution.
- The Last Month Rule states that in the event you were not HSA eligible for the entire year, you are eligible to contribute up to the full yearly limit for that year as long as you were HSA eligible on the first day of the last month of the year (December 1) and remain HSA eligible for the entire following year. If you contribute the full yearly limit under the provisions of the last month rule, but do not remain eligible during the entire following year, you will be subject to a 10% fine as well as income taxes on the contribution amount that would not have been made except for the last-month rule.
- A qualified HSA funding distribution is a once per lifetime deposit of either traditional or Roth IRA funds into your HSA. The testing period in this event ends on the last day of the 12th month following the rollover. For example, if a qualified HSA funding distribution is contributed to your HSA on August 10, 2015, your testing period begins in August 2015, and ends on August 31, 2016 .In other words, you must remain HSA eligible for 12 months following an IRA rollover or you will be subject to a 10% fine as well as income tax on the distribution amount.
3. Using HSA funds on non-qualified medical expenses: 20% fine + applicable income tax
- Part II of IRS Form 8889 concerns HSA distributions, meaning how you spent your HSA funds during that tax year. Any distribution that was not for a qualified medical expense, as determined by IRS Publication 502, is subject to income tax as well as an additional 20% tax. In the event that you are audited, you will need to provide receipts for the expenses you used your HSA funds on. If you are in violation of this, you can re-deposit the misused funds before the tax deadline in order to avoid the penalty. Contact the bank and ask how to do a “withdrawal correction.”
For more details on these penalties and other HSA guidelines, please refer to IRS Publication 969