Question: How should employers and employees address mistaken HSA contributions in excess of the statutory limit?

Short Answer: Employers can work with the HSA custodian to return excess contributions made through their payroll, but any other excess contribution will require the employee to take a corrective distribution directly from the HSA custodian.

General Rule: HSA Statutory Limit

The HSA contribution limits are adjusted annually for inflation, currently at the following levels:

2021 Contribution Limits

• Individual HDHP Coverage: $3,600

• Family (employee + at least one other individual) HDHP Coverage $7,200

Additional Notes:

• A $1,000 catch-up contribution is available for individuals who are at least age 55 by the end of the calendar year.  For more details, see our previous post: HSA Catch-Up Contributions.

• For more details on the other HDHP/HSA annual limits, see our previous post: IRS Releases 2021 Inflation Adjusted Amounts for HSAs.

• For more details on the HSA limits that apply where an employee is HSA-eligible for only part of the year, see our prior post: The HSA Proportional Contribution Limit.

For more details on everything HDHP/HSA, see our Newfront Go All the Way With HSA Guide.

—

Excess HSA Contributions through Employer’s Payroll: Employer Correction Process

If an employer contributes to an employee’s HSA in excess of the statutory limit, the employer can correct the error before the end of the calendar year by requesting that the HSA custodian return the excess contributions (adjusted for earnings) back to the employer.

Assuming the HSA custodian agrees to return the excess funds, the employer should process the correction as follows:

• Excess Employer Contributions: Retained by the employer;

• Excess Employee Contributions: Returned to the employee as taxable income subject to withholding and payroll taxes.

If the employer fails to recover the excess contributions from the custodian by the end of the calendar year, the excess contributions will need to be included as gross income on the employee’s Form W-2 for the year in which the employer made the contributions.  This may require the employer to issue a corrected Form W-2c to the employee.  Furthermore, the employee would need to take a corrective distribution of the excess funds by the tax filing deadline (generally April 15 without extension, delayed this year to May 17, 2021) to avoid a 6% excise tax owed on the excess contributions.

• For more details, see our previous post: HSA Mistaken Contributions.

Example 1:

• Tiffany has family HDHP coverage in 2021.

• In December 2021, Tiffany’s employer discovers that the employer contributions to her HSA total $7,300 ($7,200 limit) due to a mistaken excess $100 employer contribution.

• $3,100 of the contributions were employer contributions, $4,200 of the contributions were employee pre-tax contributions through payroll.

• The employer requests that the HSA custodian return the $100 excess contributions (adjusted for earnings plus administrative fees) to the employer.

• The custodian agrees to return the funds to the employer, and the employer receives the funds back by the end of 2021.

Result 1:

• The employer retains the $100 in mistaken employer contributions with no tax consequences to Tiffany.

Example 2:

• Same as Example 1, but Tiffany’s employer does not discover the error until March 2022.

Result 2:

• The employer must issue a corrected 2021 Form W-2c to Tiffany to include the mistaken contributions in Tiffany’s gross income.

• If Tiffany already filed her individual return, she will need to file an amended return (generally via Form 1040X) to report the additional income.

• Tiffany will also need to work directly with the HSA custodian to take a corrective distribution of the $100 excess contributions by her tax filing deadline (generally April 15 without extensions, delayed this year) to avoid a 6% excise tax on the excess contributions.

• The employer has no ability to recoup its excess contributions in this scenario.

Excess HSA Contributions Outside of Employer’s Payroll: Employee Corrective Distribution

Where an employee has excess contributions that were not made through the employer’s payroll, the excess contributions are purely an individual income tax issue. There is no employer role in the correction process because the employer was not responsible for excess. The corrections are therefore handled directly by the employee in coordination with the HSA custodian.

Examples of where excess contributions may occur outside of the employer’s payroll include:

• Employee changed employers mid-year, and combined contributions exceed statutory limit;

• Employee made contributions directly to the HSA outside of payroll, and combined contributions exceed statutory limit;

• Employee and spouse contributions exceeded the combined family limit for spouses.

Even though a portion of the HSA contributions may have been employer/employee contributions through payroll, those contributions through payroll by themself did not create the excess.  Accordingly, the employer does not have a basis to take corrective action.

• Note: Where an employee notifies the employer that the employee has reached or exceeded the maximum HSA limit because of contributions outside of the employer’s payroll (e.g., contributions through a prior employer or made directly to the HSA outside of payroll), the employer should discontinue all employer and employee HSA contributions.  Although the employer is not responsible for taking corrective action, the employer should not knowingly permit employees to make or receive HSA contributions through payroll that are in excess of the statutory limit.

Corrective Distribution by Tax Filing Deadline

To avoid a 6% excise tax on the excess contributions, the employee must work directly with the HSA custodian to take a corrective distribution of the excess contributions, adjusted for earnings.  The earnings portion of the corrective distribution is included in the employee’s gross income, but there are no additional taxes.  In other words, neither the 6% excise tax nor the 20% additional tax for non-medical distributions will apply.

• Note: Where the excess contribution was made pre-tax through payroll and not reported as income on the Form W-2, the excess contribution itself must also be reported as “Other Income” on the individual tax return. Where the excess contribution was made outside of payroll, the individual cannot claim a deduction for the excess contribution amount.

The general rule is the employee must take the corrective distribution by the tax filing deadline (typically April 15, delayed this year to May 17, 2021), or the later deadline if filing for an extension (typically October 15), to avoid the 6% excise tax.  The corrective distribution is reported on Line 14b of the Form 8889 filed with the individual income tax return.  It is also reported as an excess contribution distribution (Code 2) in Box 3 of the Form 1099-SA provided by the HSA custodian.

There is a special rule outlined in the IRS Form 8889 Instructions providing individuals the opportunity to take a corrective distribution up to six months after the due date of the return, including extensions.  Under that special rule, employees can work with their personal tax advisor to file an amended return with the statement “Filed pursuant to section 301.9100-2” entered at the top.  This may also require additional changes to the Form 5329 to reflect that the corrective distribution will avoid the previously applicable 6% excise tax.

The 6% Excise Tax

Employees failing to take a corrective distribution from the HSA custodian will need to report the excess contributions as subject to the 6% excise tax reported on IRS Form 5329.  They will continue to pay the 6% excise tax each year until the excess contributions are distributed.

Example 3:

• Salvador makes and receives $5,000 in HSA contributions for January through September of 2021 while in family HDHP coverage with Employer A.

• In October 2021, he changes jobs and moves to family HDHP coverage with Employer B.

• For the period from October – December 2021, Salvador makes and receives $4,000 in HSA contributions with Employer B.

Result 3:

• Salvador contributed $9,000 to the HSA in 2021, resulting in an excess contribution of $1,800 over the $7,200 family limit.

• Corrective Distribution Avoiding 6% Excise Tax: He can take an $1,800 corrective distribution (adjusted for earnings) from the HSA by his 2021 tax filing deadline (generally April 15, 2022) and include the corrective distribution in his 2021 gross income.

• 6% Excise Tax: If Salvador fails to timely take a corrective distribution, he must pay a 6% excise tax on the excess contribution each year until it is distributed.

Mistaken HSA Contributions Not Exceeding Statutory Limit: Employer Administrative or Process Error

Where an employer mistakenly contributes too much to an employee’s HSA, but those contributions do not exceed the statutory limit, a recent IRS Information Letter outlines the ability of employers to correct the error by requesting the HSA custodian return the mistaken contributions back to the employer.  This approach is available where there is clear documentary evidence demonstrating that there was an administrative or process error made by the employer.

• For full details, see our prior post: HSA Mistaken Contributions.

For more details on everything HSA, see our Newfront Go All the Way With HSA Guide.

—

Regulations

IRC §223(f)(3)(A):

(3) Excess contributions returned before due date of return.

(A)  In general. If any excess contribution is contributed for a taxable year to any health savings account of an individual, paragraph (2) shall not apply to distributions from the health savings accounts of such individual (to the extent such distributions do not exceed the aggregate excess contributions to all such accounts of such individual for such year) if—

(i)  such distribution is received by the individual on or before the last day prescribed by law (including extensions of time) for filing such individual’s return for such taxable year, and

(ii)  such distribution is accompanied by the amount of net income attributable to such excess contribution.

Any net income described in clause (ii) shall be included in the gross income of the individual for the taxable year in which it is received.

IRC §4973(a):

(a) Tax imposed.

In the case of—

—

(5) 

a health savings account (within the meaning of section 223(d)), or

—

there is imposed for each taxable year a tax in an amount equal to 6 percent of the amount of the excess contributions to such individual’s accounts or annuities (determined as of the close of the taxable year). The amount of such tax for any taxable year shall not exceed 6 percent of the value of the account or annuity (determined as of the close of the taxable year). In the case of an endowment contract described in section 408(b), the tax imposed by this section does not apply to any amount allocable to life, health, accident, or other insurance under such contract. The tax imposed by this subsection shall be paid by such individual.

IRS Notice 2004-2:

https://www.irs.gov/irb/2004-02_IRB#NOT-2004-2

Q-22. What happens when HSA contributions exceed the maximum amount that may be deducted or excluded from gross income in a taxable year?

A-22. Contributions by individuals to an HSA, or if made on behalf of an individual to an HSA, are not deductible to the extent they exceed the limits described in A-12. Contributions by an employer to an HSA for an employee are included in the gross income of the employee to the extent that they exceed the limits described in A-12 or if they are made on behalf of an employee who is not an eligible individual. In addition, an excise tax of 6% for each taxable year is imposed on the account beneficiary for excess individual and employer contributions.

However, if the excess contributions for a taxable year and the net income attributable to such excess contributions are paid to the account beneficiary before the last day prescribed by law (including extensions) for filing the account beneficiary’s federal income tax return for the taxable year, then the net income attributable to the excess contributions is included in the account beneficiary’s gross income for the taxable year in which the distribution is received but the excise tax is not imposed on the excess contribution and the distribution of the excess contributions is not taxed.

IRS Publication 969:

https://www.irs.gov/pub/irs-pdf/p969.pdf

Excess contributions.

You will have excess contributions if the contributions to your HSA for the year are greater than the limits discussed earlier. Excess contributions aren’t deductible. Excess contributions made by your employer are included in your gross income. If the excess contribution isn’t included in box 1 of Form W-2, you must report the excess as “Other income” on your tax return.

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 avoid paying 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.

IRS Form 8889 Instructions:

https://www.irs.gov/pub/irs-pdf/i8889.pdf

Excess Contributions You Make

To figure your excess contributions (including those made on your behalf), subtract your deductible contributions (line 13) from your actual contributions (line 2). However, you can withdraw some or all of your excess contributions for 2020 and they will be treated as if they had not been contributed if:

• You make the withdrawal by the due date, including extensions, of your 2020 tax return (but see the _Note_under Excess Employer Contributions, later);

• You do not claim a deduction for the amount of the withdrawn contributions; and

• You also 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.

Excess Employer Contributions

Excess employer contributions are the excess, if any, of your employer’s contributions over your limitation on line 8. If you made a qualified HSA funding distribution (line 10) during the tax year, reduce your limitation (line 8) by that distribution before you determine whether you have excess employer contributions. If the excess was not included in income on Form W-2, you must report it as “Other income” on your tax return. However, you can withdraw some or all of the excess employer contributions for 2020 and they will be treated as if they had not been contributed if:

• You make the withdrawal by the due date, including extensions, of your 2020 tax return (but see the following Note);

• You do not claim an exclusion from income for the amount of the withdrawn contributions; and

• You also 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.

Note. If you timely filed your return without withdrawing the excess contributions, you can still make the withdrawal no later than 6 months after the due date of your tax return, excluding extensions. If you do, file an amended return with “Filed pursuant to section 301.9100-2” written at the top. Include an explanation of the withdrawal. Make all necessary changes on the amended return (for example, if you reported the contributions as excess contributions on your original return, include an amended Form 5329 reflecting that the withdrawn contributions are no longer treated as having been contributed).

—

Line 14b

Include on line 14b any distributions you received in 2020 that qualified as a rollover contribution to another HSA. See Rollovers, earlier. Also include any excess contributions (and the earnings on those excess contributions) included on line 14a that were withdrawn by the due date, including extensions, of your return. See the instructions for line 13, earlier.