As background, in order to be eligible to establish and contribute to an HSA, an individual must have qualifying HDHP coverage and must have no 'impermissible' coverage. Impermissible coverage is defined as coverage that pays for medical expenses below the statutory minimum deductible for the HSA--also known as 'first dollar' coverage. Impermissible coverage can include general purpose FSAs, HRAs, Medicare, or telemedicine. This FAQ addresses the corrective options available if an employer or employee discovers that the employee was ineligible for HSA contributions.
First, this employer should seek help from outside tax counsel or their accountant, as the contributions they made could lead to tax consequences. They should also encourage the employee to seek tax advice from an experienced tax preparer. This is because the employee may need to amend their individual tax filings to correct the situation, and they’ll most likely need an expert to assist them with this. Ultimately, all HSA contributions are distributions that must be substantiated by the individual employee with the IRS.
Next, an HSA-ineligible employee won’t be able to take a tax deduction for any contributions attributable to the period of ineligibility. The employee may also be subject to a 6 percent excise tax if the impermissible contributions and any attributable earnings aren’t removed from the employee's HSA within the timeframe allowed for correcting excess contributions (generally, by the tax filing deadline of the year following the impermissible contribution). Employer contributions to employees' HSAs that are made between January 1 and the date for filing the employee's federal income tax return without extensions (i.e., April 15 for most individuals) may be allocated to the prior taxable year. Since HSAs are individual accounts, the corrective action primarily will be on the employee, who will have to correct the issue or answer to the IRS (although in some cases the employee will likely be frustrated with the employer — even though there may have just been a lack of information on the employee’s eligibility status).
If an employer makes contributions to an employee’s HSA when the employer has knowledge that the employee is ineligible, the employer could also be subject to penalties under tax withholding laws, since an employer is authorized to exclude from compensation only those amounts that it reasonably believes an employee will be able to exclude from income. If the employer doesn’t have knowledge of the impermissible coverage, then the employer wouldn’t likely be liable for any penalties. That said, there are some difficulties for the employer in having the mistaken HSA contributions it has made refunded by the employee. This is because HSA contributions aren’t forfeitable, meaning that once a contribution has been made to the employee’s HSA account, the HSA account owner has a non-forfeitable right to receive them.
We then would look to the employer's corrective action. If the employer recognized the mistake and is trying to fix it as quickly as possible, the employer may be able to request a return of the contributions from the trustee or custodian of the account if it happens in the same calendar year (because there’s a non-forfeitable exception in circumstances where the employee was never HSA eligible). Generally, the trustee or custodian can choose whether they want to send money back to the employer or just cure it through a distribution. Some trustees or custodians won’t actually return it to the employer (they treat every contribution as non-forfeitable). But all custodians should allow a curative distribution (which results in a Form 1099-SA).
The above resolution becomes more difficult if the problem has been going on for a while. In these instances, the HSA account balance is frequently depleted and the funds are no longer available. In that case, the only alternative for the employer is to include the contribution amount for the period during which the employee was ineligible as gross income on the employee's W-2, and the employee will be subject to the excise tax as noted above. In some situations, this means the employer may have to file corrected W-2s related to the year the contribution was made, which would necessitate amended filings from the employee as to those years. Again, the affected employee is usually the one who ends up very unhappy in these situations.
In summary, this situation could result in the 6 percent excise tax if HSA funds were spent and the employee (or employer on their behalf) doesn’t repay them. However, the employee could avoid the penalty if any of the following occur:
- The funds are repaid before the employee’s tax filing deadline
- The funds are still available (unspent) and are either repaid to the employer or accounted for on employee’s W2 as taxable income
- The funds are distributed directly to the employee (via 1099-SA curative distribution)
Finally, as mentioned up front, because of the potential tax consequences, we would encourage the employer to seek the assistance of outside tax counsel or their accountant in these situations. They should also encourage the employee to seek tax advice from an experienced tax preparer.