Mistaken Distribution from Your HSA? Here's How to Correct the Problem.

Mistakes happen. In this case, you can correct them.

A colleague recently asked me what she should do. She bought several HSA-qualified items and some personal products at her local pharmacy, confident that her Health Savings Account debit card would identify the qualified expenses, process payment, and leave a balance that she would cover with personal funds. After all, that's the way her Health FSA always worked.

To her surprise, the entire transaction processed. She knew that she had a problem (she conducts open-enrollment meetings for an insurer and is familiar with the list of qualified expenses). She just didn't know how to address it.

I walked Liz through her options - the same ones presented below.

Best Practice

Most leading Health Savings Account providers follow the industry best practice of restricting debit cards. They code the cards as they do Health FSA cards: They configure their cards to work at only certain businesses most likely to sell qualified goods and services through merchant codes (e.g., the business identifies as a dental office, optical shop, physician practice, or hospital).

This practice of placing guard rails on reimbursements isn't perfect. Cards can be used at a pharmacy, for example, but many items stocked at a drug store (think sodas, candy, greeting cards, and hair-care products) aren't qualified expenses. That's why another best practice is to allow the card to reimburse only qualified items in a drug or grocery store - products like cough syrup, bandages, and pain medicine - based o the product's UPC. Thus, if you purchase a prescription drug, a bottle of ibuprofen, and a drink, the card will process payment for the drug and ibuprofen and leave a balance that you must pay with personal funds.

Health Savings Account debit cards weren't always restricted, and some (obviously) still aren't. Early Health Savings Account providers were often banks that didn't have the technology to restrict cards or limit items that the card reimbursed. But in today's world of consolidation and toward providers who can administer all related employee accounts (like Health FSAs and Health Reimbursement Arrangements), most account providers have incorporated this technology to put guard rails around debit-card purchases to protect owners from compliance issues.

Substantiation

All tax-advantaged health accounts require substantiation. Health FSAs and HRAs require third-party (neither the merchant nor the participant, but rather the plan administrator) substantiation. That's why the restrictive coding and the list of qualified expenses are important on these cards: They limit the number of transactions that must be reviewed to ensure that the purchase is a qualified expense.

Health Savings Accounts require substantiation as well, though it's not third-party and not at or shortly after the point of purchase. Instead, Health Savings Account owners can spend balances on any good or service (though taxes and penalties apply when the expense isn't qualified). They must retain records in case the Internal Revenue Service audits their tax return and they must document that withdrawals are for qualified expenses only.

Solutions

So, what happens if your Health Savings Account debit card isn't restricted, you purchase non-qualified items along with qualified products, and you want to reverse the error?

Scenario: You added $15 worth of hair-care products to a transaction that included two prescription drugs and a bottle of cough suppressant. Your Health Savings Account debit card processed the full purchase.

Here are several approaches that you can take:

Correct the compliance problem promptly. You can download a Mistaken Distribution form from your Health Savings Account provider's website, complete it, enclose a check, and mail it to the provider. Your account provider will process the transaction as a mistaken distribution so that the deposit isn't applied to your contribution maximum.

Example: See scenario above. You enclose a $15 check with the Mistaken Distribution form and your account provider restores that amount to your Health Savings Account balance.

Offset the disqualified items. Another solution is to leave the transaction intact, then pay for an equivalent qualified expense with personal funds during the same calendar year (or earlier, back to the point that you established your Health Savings Account).

Example: See scenario above. The next time you incur a service that's applied to the deductible, reimburse the first $15 of the bill with personal funds. For example, if you have a bill for a $172 office visit, you log onto your Health Savings Account and direct a $157 check to your doctor. You send a personal check or provide personal debit-card information to pay the $15 balance.

You don't have to match individual distributions with individual expenses incurred. You can charge a hotel room, a tank of gas, or Powerball tickets to an unrestricted Health Savings Account debit card without running afoul of federal tax law. You simply must retain in your tax files appropriate receipts to support the amount that you insert on Form 8889 of your federal personal tax return as distributions for qualified expenses.

Example: You pay a $1,200 bill for an MRI with personal funds because you want to preserve your HSA balances. Later that year, you must replace your home's water heater. It's close to the holidays, and your budget is tight. You log onto your Health Savings Account and use the bill-pay feature to direct a $1,200 payment to your plumber. You have, in effect, simply deferred reimbursement of the MRI until later in the year. You face no tax consequences because your total amount withdrawn from your Health Savings Account matches our qualified expenses.

Note: You can find that offsetting expense not only before the end of the calendar year, but any prior year after you established your account (which, in most cases, means the date on which you initially funded your Health Savings Account). For example, I have unreimbursed expenses going back to 2009 - the year that I established my account - that I've retained for just such a contingency.

Fail to correct the error. This course is not recommended. But it may happen out of ignorance (you don't know what's a qualified, which is precisely why the best practice is to code the card to help you remain in compliance with federal tax law) or you experience a psychological rush when you face danger. Since no traditional third party reviews purchases, you won't face any consequences during or immediately after the transaction. If the error is uncovered during an audit of your personal income tax return, the Internal Revenue Service may require you to file a revised tax return to include the mistaken distribution in your taxable income, pay a 20% additional tax (unless you're age 65 or older, or disabled) as the standard penalty for reimbursing non-qualified expenses, and pay both interest and fines that accompany any errors (not just Health Savings Account-related mistakes) on your tax return.

That's a steep price.

The Bottom Line

Learn whether your Health Savings Account debit card has restricted coding. If it doesn't, you alone are responsible for segregating qualified and non-qualified items at the point of purchase. If the card has restricted coding, it should process only qualified items and leave a balance for you to pay with a form of personal funds.

Remember, there are options to correct the mistake. Understand them and use them as necessary to keep your account in compliance.

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