Can You Fix a Mistaken Distribution from Your HSA? Yes, but Maybe Hurry!

Sometimes mistakes happen. For Health Savings Account owners, there are solutions.

Have you withdrawn funds from your Health Savings Account to pay for something that's not a qualified expense under the federal tax code? If so, whether the mistake was intentional or not, or whether it was triggered by you or someone else (such as a medical provider, your insurer, or your account administrator, you can correct it. In fact, you must correct it to eliminate any tax liability and possible penalties.

Why Do Mistaken Distributions Happen?

Here are some common ways that Health Savings Account owners make mistaken distributions:

Claim reprocessed: Sometimes provider mistakenly code claims or, less common, insurers process the claims incorrectly. For example, you may undergo a routine physical that's covered in full. But your physician codes the visit as diagnostic, and your insurer applies the service to the deductible. Your provider bills you the $157 contracted rate. You pay the bill from your Health Savings Account (perhaps your account provider receives claims and you've set up your account to reimburse expenses automatically, or maybe you just returned the invoice with your Health Savings Account debit-card number in the payment section). Then you remember that the visit was preventive. You ask your doctor to resubmit the claim with a preventive-visit code. The insurer processes that claim and wipes out your financial responsibility. The net result is that you withdraw $157 from your Health Savings Account without a corresponding actual qualified expense, which will trigger taxes and penalties if not corrected. Note that even though your provider or insurer made the mistake on the claim, you're responsible for all Health Savings Account transactions.

Your mistake: You may have an unrestricted Health Savings Account card that allows you to purchase any items, not just qualified expenses. You use your Health Savings Account card (either consciously or inadvertently) to fill your gas tank or purchase a meal at a restaurant. That expense isn't qualified, so the distribution is subject to taxes and penalties. Or maybe you, as I did recently, instruct your spouse to pull out your debit card attached to your Limited-Purpose Health FSA and Health Savings Account to pay for two dental crowns. You wanted to exhaust your Health FSA, but you wanted to pay the balance with personal funds to preserve your Health Savings Account balances. But the card spent the Health FSA balance, then withdrew the balance owed from the Health Savings Account. It's a qualified expense, so there are no taxes or penalties, but you want to return the money to your account to build your balances to reimburse qualified expenses in retirement.

Solution No. 1: Reimburse the Account

On approach to solving this problem is to return the mistaken distribution to your Health Savings Account. In the example of the $157 office visit above, that means depositing $157 to your account. Your personal finances are no more strained because both transactions are of the same dollar amount and involve the same account. You took funds out and you simply return them when your provider issues a refund.

Be sure to work with your account administrator. You'll probably have to complete a simple one-page form to document that they check that you're sending is to correct a mistaken distribution. Otherwise, the deposit will be recorded as a contribution. This is a problem if you fund your account to the Internal Revenue Service maximum, since you won't be able to deposit the final $157 (again, using our example above) of your contribution limit. Also, not having the deposit coded as a mistaken distribution still leaves you with $157 of non-qualified expenses, which are subject to income taxes and a 20% additional tax as a penalty (the penalty applies unless you're age 65 or older, disabled, or dead).

Solution No. 2: Match Expenses

The second option is to (again, using our example above) simply not reimburse the next $157 of qualified expenses. For example, you incur $157 of financial responsibility for two dental fillings. You pay the bill with personal funds. You've corrected the mistaken distribution.

This solution illustrates an important point: The IRS doesn't care whether you charge a water heater or a cruise to your Health Savings Account. The recipient of any withdrawn funds doesn't matter. Your compliance responsibility is to report your activity on you annual income tax return. If you have $3,000 of distributions and $3,000 of qualified expenses, it doesn't matter whether you bought a ticket in October for Coach Mike Krzyzewski's final game at Cameron Indoor Stadium from your Health Savings Account.

And here's a bonus: Those unreimbursed expenses can have dates of service any time after you were HSA-eligible and established your Health Savings Account. In most cases, that means the date that your account was initially funded. Thus, if you established your account in, say, 2018, didn't reimburse a six-month supply of contact lenses ($160) in 2019, and retained the receipt, you simply file that detailed receipt in your 2021 tax file and you're prepared if your tax return is audited.

By the way, you got a great deal by buying your ducat ahead of the big date. Ticket prices in the aftermarket were, on average, higher than this year's Super Bowl admission, and some approached $100,000. Also, for you serious fans, note the picture accompanying the $100,000 article of a young Coach K and longtime ESPN basketball broadcaster Jay Bilas - with hair - who's seated right under Coach K's right hand, to the left of Martin Nessley. This was a Blue Devil team during my time at Duke.

Tip: Travel

If you don't have receipts to apply against the $157 withdrawal, here's a potential source of qualified expenses: Unreimbursed mileage and parking for medical services. The mileage figure for 2021 (16¢ per mile) requires a lot of mileage to make a meaningful dent in the distribution. But if you had to park 10 times at $10 each for visits to your local hospital for outpatient care for a chronic condition ($100) and the hospital is a 20-mile trip each way (400 miles at 16¢ = $64), you've covered the expense. Simply document these expenses in our tax records (for example, bank statements with debit-card transactions at the hospital parking lot on the dates of service).

You can't claim just any travel. But if you traveled as a result of a qualified expense incurred by you, your spouse, or a tax dependent (at the time of the service, not in the year that you claim the expense), it's a qualified expense. Note that the IRS-approved travel allowance varies from year to year, so be sure to apply the right amount to travel each year.

And remember, you can go back to the date that you established your Health Savings Account. You'll need documentation - an Explanation of Benefits from your insurer or a detailed provider invoice - to show the date and location of the service, as well as a description of the expense to ensure that it's qualified.

Beware the Deadline

Whichever method you choose to correct the mistaken distribution, beware that you must take action before the due date of your income taxes for the year in which the mistaken distribution occurred. In other words, if you withdrew the funds Oct. 6, 2021, to pay the $157 physician visit that was later recoded to zero out your financial responsibility, you must correct the error, using either option above, by April 18, 2022.

The Bottom Line

It takes a little work to correct a mistaken distribution, whether it's completing paperwork to return the funds or gathering documents to post qualified expenses otherwise not reimbursed against the withdrawal. But it can be done. Remember, whether you, your provider, your insurer, or even your account provider makes the mistake, you alone are responsible for fixing it and brining your Health Savings Account back into compliance.

Now you know how.

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