Healthcare can be very expensive, but with a tax-advantaged tool like the Health Savings Account (HSA), it can help lower costs. A high deductible healthcare plan (HDHP) – a requirement to open and contribute to an HSA – allows healthcare consumers to save on premiums and set aside tax-free money for out-of-pocket medical expenses. But, as with any tax-advantaged financial tool, there is a limit on how much account holders can contribute to their HSAs every year.
If you go over the annual contribution limit, the IRS can penalize you. Fortunately, there are two different ways to handle HSA excess contributions which can help you avoid paying a penalty.
What are excess HSA contributions?
Simply put, excess HSA contributions is any amount over the annual limit.
In 2020, the maximum contribution limits for HSAs were $3,550 for individuals and $7,100 for families. Account holders age 55 and above can contribute an additional $1,000 per year as a “catch-up” contribution. These limits are based on inflation, and generally increase by moderate amounts every year.
To maximize your tax savings, you want to contribute up to the limit, but no more.
What is the penalty?
When you go over the maximum contribution limits, the penalty you pay depends on the overrun amount. Currently, the IRS penalty equals 6 percent of your excess contributions. For example, if you have a $100 excess contribution, your fine would be $6.00; if you contributed $1,000 over, it would be $60.
This penalty is called an “excise tax,” and applies to each tax year the excess contribution remains in your account. This means you will incur the 6 percent excise tax every year until you remove it from the account or apply it to a future year.
What causes excess HSA contributions?
Most people contribute the same amount to their HSA on a weekly or monthly basis, or with each paycheck. Simply divide the annual limit by the number of contributions to figure out how much you can put in. However, some situations could put you over the limit:
- Multiple contributors. Aside from yourself, anyone can contribute to your HSA. This includes a friend, a relative, or your employer. Since the annual limit applies to the total sum, you have to keep track of contributions made by others as well as your own.
- Incorrect calculations. Even with digital calculators, people can make mistakes. If you miscalculate the size of your regular contributions, you can go over the limit. It pays to check your contribution each pay period, and you can always adjust your contributions at any time for any reason throughout the year.
- Irregular contributions. HSA contributions don’t have to be on a regular basis. You can contribute any time you want, which some people prefer over regular pay period contributions. Others may vary the size of their contributions based on their cash flow at any given time. If you take one of these approaches, track your contributions closely.
- Eligibility issues. Most people automatically calculate their regular contributions based on the assumption of a year’s eligibility. But if you’re new to your company, you may have an introductory period before you become eligible to open an HSA account. Or, perhaps you contributed a large part of the maximum limit early in the year (called front-loading) and then lost your HSA eligibility before the end of the year. Either situation makes you eligible for less than the full year, which can cause an HSA excess contribution. Contribution limits can also change depending on an updated coverage status, due to marriage, divorce, new child, etc.
Fixing Excess HSA Contributions
As mentioned, the IRS provides two ways of fixing extra contributions.
- One option is to remove the excess amount from your HSA in the tax year that it occurred. This means you have until your tax due date to make the correction (usually April 15). You must also remove any earnings on your excess contributions.
- The other option is to apply your HSA excess contributions to the following year.
Removing Excess Contributions
For most people, the removal method is the preferred option. It is relatively simple to do, and it takes care of the problem once and for all. It allows you to avoid paying a penalty as long as three criteria are met. You must:
- Withdraw the excess contributions no later than the due date of your tax return for the year the contributions were made. These withdrawals will be considered taxable income.
- Take out any income earned on the withdrawn contributions during the year they were made. This will also be taxable income.
- Include the earnings in “Other Income” on the tax return for the year you withdraw the contributions and earnings.
You can withdraw some or all of the excess contributions, but you will have to pay an excise tax on any amount you leave in the HSA.
When removing excess contributions from your account, you must inform your HSA trustee, otherwise they won’t know to do it. The excess funds that were withdrawn will be listed on Form 1099-SA as a distribution (in Box 1) for the tax year in which the distribution was taken. Earnings on excess contributions withdrawn will be in Box 2 and included in Box 1. Form 5498-SA will report the market value of your HSA at the end of the calendar year, the total contributions made within the calendar year, and the total contributions for the tax year through the tax filing deadline, typically April 15. The account owner should keep Form 5498-SA for record keeping purposes, but is not required to submit it to the IRS.
Future Year Option
The second way to avoid the HSA excess contributions penalty is through the “future year method.” It involves deducting some or all of your HSA excess contributions and applying them to a future year. The IRS does not allow you to apply more than you have in excess. Keep in mind that moving the excess to the following year counts towards that year’s annual contribution limit.
The future year method is more complicated than the removal method, especially if you have earnings from any of the excess contributions. If you opt to roll forward some, but not all, of the excess contributions, you will owe the 6 percent tax on any that are not applied to a future year. Both methods must be completed before your tax filing deadline or you will be charged the excise tax. Consider filing an extension on your taxes to give you more time.
This article does not constitute tax or legal advice and should not be relied upon as instructions to complete your State or Federal tax return. If you have specific questions on how to report excess HSA contributions or distributions on your tax return, please consult a qualified tax or legal advisor.