Question: How can employees correct a mistaken non-medical HSA distribution to avoid income taxes and the 20% additional tax?

Short Answer: Where there is clear and convincing evidence that the amount was distributed because of a mistake of fact due to reasonable cause, employees can work with the HSA custodian to return the mistaken distribution by the following April 15. The correction process of returning the funds to the HSA allows employees to avoid taxation and the 20% additional tax that would otherwise apply for a non-medical distribution.

General Rule: HSA Funds Can Be Used for Any Purpose

Unlike a health FSA or HRA, the HSA can be used for both medical and non-medical expenses. The HSA is an account owned by the employee with no administrative gatekeeper to limit HSA distributions.

• For more details: Newfront Go All the Way with HSA Guide

Medical Distributions: Tax-Free

HSAs can reimburse only IRC §213(d) qualified medical expenses on a tax-free basis. The best general IRS overview of what constitutes a §213(d) medical expense is IRS Publication 502. 

Medical expenses will qualify when taken for the employee HSA holder, the employee’s spouse, the employee’s children under age 19 (or under age 24 if a full-time student), and the employee’s tax dependents.

• For more details: HSAs and Family Members.

Although in almost all circumstances the Publication 502 list of §213(d) medical expenses mirrors those expenses eligible for tax-free HSA distributions, there are a few differences. The slight modifications to the list of reimbursable expenses for account-based plans are set forth in IRS Publication 969.

The most significant discrepancy is the general exclusion of premium expenses from the list of HSA-qualified medical expenses. Except in four enumerated situations, use of an HSA to pay for premium expenses would be a non-medical distribution.

• For more details: HSA Distributions for Premium Expenses

Non-Medical Distributions: Subject to Income Taxes and a 20% Additional Tax

The general rule is that there are two adverse tax consequences of taking a non-medical HSA distribution:

1. The distribution will be includible in gross income; and

2. The distribution will be subject to a 20% additional tax.

The HSA owner must report non-medical distributions on the Form 8889(Lines 14a, 16, and 17b), which is included with the individual income tax return (Form 1040). Failure to properly report non-medical distributions is subject to IRS audit.

Note: The 20% additional tax does not apply to non-medical distributions made after the HSA owner dies, becomes disabled, or reaches age 65.

• For more details: Using an HSA for Non-Medical Expenses.

Avoiding Taxation for a Mistaken HSA Distribution: Return Funds by April 15

In some cases, employees will take a mistaken non-medical distribution from their HSA for an amount they intended to qualify as a tax-free medical expense. For example, the employee may have misunderstood whether a particular item or service qualified as a medical expense, whether an individual’s expenses qualified for tax-free distributions, or the amount of cost-sharing the HDHP would cover. Absent an exception, the standard taxation and 20% additional tax would apply for any such distribution because it would not qualify as a tax-free medical distribution.

However, the IRS permits employees to avoid taxation (including the 20% additional tax) where there is clear and convincing evidence that the amounts were distributed from an HSA because of a mistake of fact due to reasonable cause. In these situations, the employee will need to repay the mistaken distribution to the HSA no later than April 15 following the first year the employee knew or should have known the distribution was a mistake.

The HSA custodian may rely on the employee’s representation that the distribution was, in fact, a mistake when processing the repayment.

Note: The HSA custodian is not required to allow employees to return mistaken distributions to the HSA. This is an optional feature for the HSA custodian to offer. If the HSA custodian does not offer the option to return the funds, the employee will be subject to income taxes and (if applicable) the 20% additional tax for the non-medical distribution.

Example 1:

• Din Djarin is enrolled in the Bounty Hunters’ Guild HDHP and contributes to an HSA.

• He is currently acting as the legal guardian for a child Grogu, who qualifies as his tax dependent.

• Din looks up speech therapy, confirms it qualifies as a medical expense, and proceeds to use his HSA to pay $150 for Grogu’s speech therapist bill.

• The HDHP later reprocesses Grogu’s claim and determines that Din overpaid because the appropriate cost-sharing was $100. Din receives a $50 refund from the provider.

Result 1:

• There is clear and convincing evidence that Din’s $50 excess HSA distribution was a mistake of fact due to reasonable cause.

• He has until April 15 of the year following discovery of the overpayment to repay the $50 excess distribution to his HSA.

• If Din fails to return the $50 mistaken distribution by April 15, or if the HSA custodian refuses to accept the repayment, that $50 will be subject to income taxes and the 20% additional tax for the non-medical distribution.

• Alternatively, if Din has incurred other qualifying medical expenses that year of at least $50 for which he has not taken a distribution, Din can substitute with other qualifying amounts by forgoing a distribution for at least $50 to offset the mistaken amounts.

IRS Reporting of Mistaken Distribution Repayments

The IRS Form 1099-SA and 5498-SA Instructions (addressing HSA distributions and contributions respectively) direct the HSA custodian accepting the return of a mistaken distribution not to report the mistaken distribution on Form 1099-SA. If the Form 1099-SA has already been filed with the IRS including the distribution, the custodian is to correct the Form 1099-SA filing (and the version provided to the HSA holder) as soon as the custodian becomes aware of the error.

Example 2:

• Same situation as Example 1.

• The HSA custodian Mando Bank agrees to accept repayment of Din’s mistaken distribution.

• Din successfully makes the repayment of the mistaken distribution to the HSA by the following April 15.

Result 2:

• Mando Bank will adjust the Form 1099-SA to remove the mistaken distribution.

• Din will not be subject to taxation or the 20% additional tax for the $50 amount returned to the HSA, and therefore he will not report them as taxable distributions (Lines 14a, 16, and 17b) on his Form 8889.

Summary

The IRS Form 8889 Instructions succinctly summarizes the mistaken distribution situation as follows:

“Note. There may be very limited and unusual circumstances in which you may be able to return mistaken distributions such that the amount will not be subject to the additional tax.”

Those “very limited and unusual circumstances” apply where employees can represent to having clear and convincing evidence that the amount was distributed from the HSA because of a mistake of fact due to reasonable cause. In those situations, employees can work with their HSA custodian to return the mistaken distribution to the HSA by April 15 of the following year—and thereby avoid income taxes and the 20% additional tax on that amount.

Relevant Cites:

IRS Notice 2004-50:

Q-37. An account beneficiary receives an HSA distribution as the result of a mistake of fact due to reasonable cause (e.g., the account beneficiary reasonably, but mistakenly, believed that an expense was a qualified medical expense and was reimbursed for that expense from the HSA). The account beneficiary then repays the mistaken distribution to the HSA. Is the mistaken distribution included in gross income under section 223(f)(2) and subject to the 10 percent [Newfront Note: Increased to 20%] additional tax under section 223(f)(4) or subject to the excise tax on excess contributions under section 4973(a)(5)?

A-37. If there is clear and convincing evidence that amounts were distributed from an HSA because of a mistake of fact due to reasonable cause, the account beneficiary may repay the mistaken distribution no later than April 15 following the first year the account beneficiary knew or should have known the distribution was a mistake. Under these circumstances, the distribution is not included in gross income under section 223(f)(2), or subject to the 10 percent [Newfront Note: Increased to 20%] additional tax under section 223(f)(4), and the repayment is not subject to the excise tax on excess contributions under section 4973(a)(5). But see Q&A 76 on the trustee’s or custodian’s obligation to accept a return of mistaken distributions.

…

Q-76. Must the trustee or custodian allow account beneficiaries to return mistaken distributions to the HSA?

A-76. No, this is optional. If the HSA trust or custodial agreement allows the return of mistaken distributions as described in Q&A 37, the trustee or custodian may rely on the account beneficiary’s representation that the distribution was, in fact, a mistake.

IRS Instructions for Forms 1099-SA and 5498-SA:

HSA Mistaken Distributions

If amounts were distributed during the year from an HSA because of a mistake of fact due to reasonable cause, the account beneficiary may repay the mistaken distribution no later than the due date of the tax return (not counting extensions) following the first year the account beneficiary knew or should have known the distribution was a mistake. For example, the account beneficiary reasonably, but mistakenly, believed that an expense was a qualified medical expense and was reimbursed for that expense from the HSA. The account beneficiary then repays the mistaken distribution to the HSA.

Under these circumstances, the mistaken distribution is not included in gross income, is not subject to the additional 20% tax, and the repayment is not subject to the excise tax on excess contributions. Do not treat the repayment as a contribution on Form 5498-SA, HSA, Archer MSA, or Medicare Advantage MSA Information.

As the trustee or custodian, you do not have to allow beneficiaries to return a mistaken distribution to the HSA. However, if you do allow the return of the mistaken distribution, you may rely on the account beneficiary's statement that the distribution was in fact a mistake. See Notice 2004-50, 2004-33 I.R.B. 196, Q/A-76, available at IRS.gov/irb/2004-33_IRB#NOT-2004-50. Do not report the mistaken distribution on Form 1099-SA. Correct any filed Form 1099-SA with the IRS and the account beneficiary as soon as you become aware of the error. See Corrected Returns on Paper Forms in the current General Instructions for Certain Information Returns for more information.

IRS Notice 2004-2:

Q-25. How are distributions from an HSA taxed?

A-25. Distributions from an HSA used exclusively to pay for qualified medical expenses of the account beneficiary, his or her spouse, or dependents are excludable from gross income. In general, amounts in an HSA can be used for qualified medical expenses and will be excludable from gross income even if the individual is not currently eligible for contributions to the HSA.

However, any amount of the distribution not used exclusively to pay for qualified medical expenses of the account beneficiary, spouse or dependents is includable in gross income of the account beneficiary and is subject to an additional 10% [Newfront Note: Increased to 20%] tax on the amount includable, except in the case of distributions made after the account beneficiary's death, disability, or attaining age 65.

Q-26. What are the “qualified medical expenses” that are eligible for tax-free distributions?

A-26. The term “qualified medical expenses” are expenses paid by the account beneficiary, his or her spouse or dependents for medical care as defined in section 213(d) (including nonprescription drugs as described in Rev. Rul. 2003-102, 2003-38 I.R.B. 559), but only to the extent the expenses are not covered by insurance or otherwise. The qualified medical expenses must be incurred only after the HSA has been established. For purposes of determining the itemized deduction for medical expenses, medical expenses paid or reimbursed by distributions from an HSA are not treated as expenses paid for medical care under section 213.

Disclaimer: The intent of this analysis is to provide the recipient with general information regarding the status of, and/or potential concerns related to, the recipient’s current employee benefits issues. This analysis does not necessarily fully address the recipient’s specific issue, and it should not be construed as, nor is it intended to provide, legal advice. Furthermore, this message does not establish an attorney-client relationship. Questions regarding specific issues should be addressed to the person(s) who provide legal advice to the recipient regarding employee benefits issues (e.g., the recipient’s general counsel or an attorney hired by the recipient who specializes in employee benefits law).