I had an HSA and spouse enrolled in FSA

Trying to correct a mistaken error.  I have an individual HDHP & have been contributing to an HSA.  I am not covered under my spouse's medical plan (only dental and vision) and in 2020 my husband enrolled in an FSA. It is a general purpose FSA because it can be used for doctors visits. I'm just finding out now that it's an issue and would have made me ineligible to contribute to my HSA.  Since this has gone on for 4 years, how do we correct this error and what are the penalties? 

I'd suggest consulting with a personal tax adviser on this one because the issues spans back multiple years and therefore there are potential excise taxes spanning multiple years.

In general--

The spouse's general purpose health FSA was unfortunately disqualifying coverage for both the spouse and you.  I've copied the relevant cite below for reference.

• Here's an overview: https://www.newfront.com/blog/hsa-interaction-health-fsa-2

For 2024 contributions, you will need to have the HSA custodian process a corrective distribution.  That will avoid a 6% excise tax that would otherwise apply for the excess contributions.

For 2023 contributions, you may be able to take advantage of a special rule outlined in the IRS Form 8889 Instructions providing individuals the opportunity to take a corrective distribution up to six months after the due date of the return, including extensions.  Under that special rule, you can work with your personal tax advisor to file an amended return with the statement “Filed pursuant to section 301.9100-2” entered at the top.  

For contributions prior to 2023, you will still need a corrective distribution, but a 6% excise tax will apply on those ineligible contributions.  The 6% excise tax reported on IRS Form 5329.

• Here's an overview: https://www.newfront.com/blog/correcting-excess-hsa-contributions

IRS Notice 2005-86:

https://www.irs.gov/pub/irs-drop/n-05-86.pdf

Interaction Between HSAs and Health FSAs

Section 223(a) allows a deduction for contributions to an HSA for an “eligible individual” for any month during the taxable year. An “eligible individual” is defined in § 223(c)(1)(A) and means, in general, with respect to any month, any individual who is covered under an HDHP on the first day of such month and is not, while covered under an HDHP, “covered under any health plan which is not a high-deductible health plan, and which provides coverage for any benefit which is covered under the high-deductible health plan.”

In addition to coverage under an HDHP, § 223(c)(1)(B) provides that an eligible individual may have disregarded coverage, including “permitted insurance” and “permitted coverage.” Section 223(c)(2)(C) also provides a safe harbor for the absence of a preventive care deductible. See Notice 2004-23, 2004-1 C.B. 725. Therefore, under § 223, an individual who is eligible to contribute to an HSA must be covered by a health plan that is an HDHP, and may also have permitted insurance, permitted coverage and preventive care, but no other coverage. A health FSA that reimburses all qualified § 213(d) medical expenses without other restrictions is a health plan that constitutes other coverage. Consequently, an individual who is covered by a health FSA that pays or reimburses all qualified medical expenses is not an eligible individual for purposes of making contributions to an HSA. This result is the same even if the individual is covered by a health FSA sponsored by a spouse’s employer.

Slide summary:

2024 Newfront Go All the Way with HSA Guide