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Taxation and Health Insurance

What are the tax issues associated with health insurance?

Two aspects of your health insurance plan may affect your income tax calculations: the premiums and the benefits. There are many variables that impact the tax treatment of your health insurance premiums and benefits. And if you don't have qualifying health insurance, you may face a penalty tax beginning in 2014.

Taxation and premiums

Employer-paid premiums are excluded from income

In general, you can exclude from your income for tax purposes any health insurance premiums (including Medicare) paid by your employer. The premiums can be for insurance covering you, your spouse, and any dependents. This rule holds true regardless of whether premiums are for an employer-sponsored group policy or an individual policy. You can even exclude premiums your employer pays when you are laid off from your job.

Caution: It is worth noting a few exceptions to this general rule. First, a partner can't exclude from income any premiums paid by the partnership. Second, a 2 percent S corporation shareholder can't exclude any premiums paid by an S corporation. Third, an employee is taxed on the value of employer-provided health benefits for the employee's domestic partner, unless the partner is a dependent of the employee.

Employer reimbursement of premiums is typically not taxable income

If you pay the premiums on your health insurance policy and receive a reimbursement from your employer for these premiums, the IRS has ruled that the amount of the reimbursement is not taxable income. However, if your employer simply pays you a lump sum that may be used to pay health insurance premiums but is not required to be used for this purpose, this amount is taxable.

Self-paid premiums are typically not deductible

The deductibility of health insurance premiums follows the rules for deducting medical expenses . If you itemize deductions and your unreimbursed medical expenses exceed 10 percent of your adjusted gross income (AGI) in any tax year, you may deduct the amount by which your unreimbursed medical expenses exceed this 10 percent threshold. Unreimbursed medical expenses include, among other things, the cost of prescribed drugs and premiums for medical insurance that provides for reimbursement or indemnity for medical care.

Tip: Premiums for Medicare Part B, dental coverage, contact lens coverage, and prescription coverage can all be included when determining whether your unreimbursed medical expenses qualify for the deduction.

Technical Note: If you pay the premiums for a policy that offers both medical and nonmedical benefits, the medical portion is deductible if:

  • The charge for the medical portion is reasonable, given the overall premium
  • The charge for the medical portion is set forth specifically in either the policy or a statement issued by the insurance company

Caution: Premium payments for disability income insurance, life insurance, and accidental death and dismemberment insurance aren't deductible.

Tip: Payments for qualified long-term care insurance are deductible , subject to limits based on age. These limits are adjusted annually for inflation.

Caution: Taxpayers age 65 and older may use the 7.5 percent floor on itemized deductions for medical expenses until 2017, after which time the floor increases to 10 percent.

There are special rules for the self-employe


In addition to the general rule of deducting premiums as medical expenses, self-employed individuals can deduct their health insurance premiums as business expenses. These deductions aren't limited to amounts over 10 percent of AGI as are medical expense deductions; they are limited, though, to amounts less than an individual's earned income from the business for which the health insurance plan was established. The definition of self-employed individuals includes partners and 2 percent S corporation shareholders. If you meet the definition of a self-employed individual, you can deduct 100 percent of the premiums for insuring yourself, your spouse, and your dependents.

Caution: To claim this business expense deduction, you must show a net profit for the year and can't be eligible to participate in your employer's or your spouse's employer's subsidized health plan. If you are eligible for employer-subsidized health insurance in any calendar month, you can't claim the deduction for that month.

Taxation and benefits

Reimbursement for benefits received under an employer-sponsored plan are typically excludable

You can generally exclude from income reimbursements for medical expenses you receive from your employer's health insurance plan. These reimbursements can be for your own medical expenses or those of your spouse or dependents. The exclusion applies regardless of whether your employer provides group insurance or individual insurance or serves as a self-insurer. The reimbursements can be for actual medical care or for insurance premiums on your own health insurance. Note that there is no dollar limit on the amount of tax-free medical reimbursements you can receive in a year.

Caution: If your total reimbursements for the year exceed the total of your actual medical expenses, you may have to include at least some of the excess in your income. If you pay 100 percent of the insurance premium or the cost of a self-insured plan, you will still be able to exclude this excess reimbursement. If, however, your employer makes contributions for some or all of your health insurance, you must include a portion of the excess that corresponds to the extent of your employer's contributions.

Caution: You can't exclude reimbursements for medical expenses that you deducted last year or some prior year.

Example(s): Hal had surgery to repair torn ligaments in his knee in October of Year 1. He paid his bill in December of Year 1 and claimed a deduction on his Year 1 income taxes. He filed a claim with his health insurance in February of Year 2 and received reimbursement in August of Year 2. Hal can't exclude these insurance benefits from taxable income in Year 2. He must include them in his Year 2 income to the extent of his deduction in Year 1.

Benefits received under an individual plan are typically excludable

You can also exclude benefits paid for medical expenses under an insurance plan for which you pay the premiums. This situation might arise if your employer offers a health insurance plan but doesn't pay the premium for you, or if you don't receive health insurance from an employer and simply purchase it for yourself.

Nondiscrimination rules for self-insured plans for employees

An employer that offers a self-insured plan can't discriminate in favor of highly compensated individuals concerning either plan eligibility or the level of benefits. If it does, these highly compensated employees won't be able to exclude all their benefits from income. In general, a highly compensated individual falls into one or more of these three categories:

  • One of the five highest paid officers
  • Someone owning more than 10 percent in value of the business's shares
  • Someone whose salary is in the highest 25 percent at the business

According to the Internal Revenue Code, a plan discriminates as to eligibility unless it satisfies one of these two requirements:

  • It benefits at least 70 percent of all employees or at least 80 percent of all the eligible employees where at least 70 percent of all employees are eligible to benefit
  • It benefits employees under a classification that the Internal Revenue Service has found doesn't discriminate in favor of highly compensated individuals

A plan discriminates with respect to benefits unless it offers the same benefits to highly compensated employees and all other participants.

 

Tip: The nondiscrimination rules are quite technical; an in-depth treatment is beyond the scope of this discussion. If you think they might apply to your situation, consult additional sources for more details.

Tax on individuals without adequate health coverage

Adequate health coverage

Beginning 2014, U.S. citizens and legal residents will generally be required to maintain adequate health-care coverage, or face a penalty tax. Acceptable coverage will include:

  • Government-sponsored programs including Medicare, Medicaid, Children's Health Insurance Program (CHIP), coverage for members of the U.S. military, veterans health care, and health care for Peace Corps volunteers
  • Eligible employer-sponsored plans including governmental plans, church plans, grandfathered plans, and other group health plans offered in the small or large group market within a state
  • Plans in the individual market
  • Grandfathered group health plans
  • Other coverage recognized by the U.S. Department of Health and Human Services and the Treasury Department

Penalty tax

The penalty tax (which takes full effect in 2016) will generally be the greater of $695 per year for each uninsured adult in a household, up to a maximum of three times that amount ($2,085) per family, or 2.5% of household income exceeding a specified threshold (the amount required to necessitate filing a federal income tax for the year).

The tax will be phased in: Beginning in 2014, the penalty tax is the greater of $95 per uninsured (up to $285 per family) or one percent of household income exceeding the threshold. In 2015, the amounts will be $325 per uninsured (up to $975 per family) and 2 percent of household income.

Tip: An additional cap on the penalty tax applies. The penalty tax will not exceed the national average annual premium for bronze level health plans offered through exchanges (the new health insurance exchange programs being established in accordance with the health-care reform legislation) for a household of similar size.

Tip: Families will pay half the appropriate dollar amount for uninsured individuals under age 18.

Tip: Beginning after 2016, the maximum penalty tax will be increased annually by a cost of living adjust