Many times a letter from the IRS is considered an audit. A common letter we see from new clients is an IRS letter saying our new client forgot to include an HSA distribution as income on a previous year’s tax return. These letters can leave you with all sorts of warm and fuzzy feelings toward the IRS and the professional who prepared the return for you.
HSAs and How They Function
Quick recap on HSAs: HSAs are basically a fancy IRA that lets you withdraw money tax and penalty free if the distribution is for unreimbursed “qualified medical expenses.” (Good concise list of qualified medical expenses. IRS not concise and wordy list of qualified medical expenses.) HSAs and IRAs are very similar other than that exception. You can contribute pre-tax dollars up to a limit each year. The growth inside the HSA will be taxed when you withdraw it. If you withdraw early, penalties apply.
This may come as a surprise, but while the tax law allows those distributions for medical expenses to be tax free, the IRS wants you to pay tax on it. But at the same time, more than 95% of these IRS HSA letters can be avoided if your tax return is filed the right way. Fill out form 8889 correctly.
At the end of the day, if you prepare your own returns and are not a full time tax professional, you don’t know what you don’t know. Most the times these letters happen because it is very easy to forget you need to include these stupid little things on your tax return. The real challenging part of this, and the reason most forget, is because HSAs don’t send these forms out until after April (That is what we see in most cases. Of course there are always exceptions in the tax world.)
There is Hope
We recently just helped a client fight this exact letter he got because his previous accountant screwed up. We provided proof that his medical expenses qualified. We sent that proof multiple times because the IRS is incompetent with its processes; We had a few phone calls with the auditor to explain the law he is supposed to know already but didn’t; We gave the IRS two months to take the 5 minutes it needed to process our proof, and BOOM, we get the IRS letter in the mail confirming they aren’t going to assess any tax or penalty on our client.