INSURANCE 101: Taxation of Health Insurance

Taxation of Individual Health Insurance

Medical Expense Insurance Premiums and Benefits
Medical expenses that are covered through an insurance policy, such as an operation or the cost of services for a doctor’s visit, are considered ‘reimbursed’ medical expenses and cannot be deducted from a policyholder’s annual income.

Medical expenses that are not covered through an insurance policy, such as policy premiums, deductibles, copays, coinsurance amounts, and medical expenses not reimbursed through the policy, are considered ‘unreimbursed’ medical expenses.

Unlike reimbursed medical expenses which cannot be deducted, unreimbursed medical expenses can be deducted only if the policyholder’s annual unreimbursed medical expenses exceed 10% of his or her adjusted gross annual income.  If he or she exceeds this 10% threshold, only the excess of 10% will be considered tax deductible.

Example 1

Tim’s unreimbursed medical expenses equal $4,500 and his adjusted gross income for the year is $50,000.  Based on his adjusted gross income, he would not be able to deduct any unreimbursed medical expenses because he did not exceed the 10% or $5,000 ($50,000 x 10% = $5,000) threshold.

Remember, if the policyholder’s annual unreimbursed medical expenses do not exceed 10% of his or her adjusted gross annual income, none of the unreimbursed medical expenses are deductible.

Example 2

Tim’s unreimbursed medical expenses equal $4,500 and his adjusted gross income for the year is $40,000.  Based on his adjusted gross income, he would exceed the 10% ($40,000 x 10% = $4,000) threshold and would be able to deduct $500 ($4,500 – $4,000 = $500) of his unreimbursed medical expenses.

Note: Individuals born before January 2, 1950 can deduct annual unreimbursed medical expenses that exceed 7.5% of their adjusted gross annual income, as opposed to 10% for individuals born on or after this date.

Medical expense policy benefits are received tax-free by the insured; however, it is important to note that medical expense benefits cannot exceed actual medical expenses incurred by the insured.

Long-term Care Insurance Premiums and Benefits

Both medical expense and long-term care policy premiums are considered medical expenses, and are included in annual deductions when meeting the 10% or 7.5% unreimbursed medical expense thresholds.

LTC benefits are received income tax-free by the insured up to the amount of incurred expenses.  Any benefits exceeding the actual costs by the insured are considered taxable, as is the case under a fixed benefit LTC policy when daily benefits payable exceed daily expenses incurred.

The 10% and 7.5% expense limits apply to medical expense and long-term care policies, but do not apply to disability insurance.

Disability Insurance Premiums and Benefits

Premiums paid for individual disability insurance are not tax deductible from a policyholder’s annual income; however, disability income payments are received income tax-free by the insured and are usually expressed as a percentage of the insured’s pre-disability income amount.

Disability benefits cannot exceed pre-disability income levels and are often paid out as a percentage of the insured’s actual pre-disability income amount to encourage the individual to return back to work as soon as possible to reach his or her full pre-disability earnings.

Individuals who are considered chronically ill must be re-certified as such by their insurer on an annual basis to continue to receive disability benefits on a long-term basis.

Taxation of Group Health Insurance
Employer-based group health insurance represents the majority of the health insurance in America.  Many employers provide health insurance in the form of medical expense coverage, LTC and disability income policies for employees as a benefit of employment.

Group Medical Expense Insurance Premiums and Benefits

Employee-paid premium contributions in a group medical expense policy are not tax deductible; however, employer-paid premium contributions in a group policy are not taxable to the employee and are not included in an employee’s annual income, thus lowering the employee’s taxable income.

Employee medical expense benefits are received income tax-free, but benefits cannot exceed actual expenses.

Similar to personal excess medical expenses, if an employee’s annual unreimbursed medical expenses exceed 10% of his or her adjusted gross annual income (7.5% for individuals born before January 2, 1950), any unreimbursed medical expenses that exceed this 10% (or 7.5%) are deductible from the employee’s annual income.

Group Long-term Care Insurance Premiums and Benefits

Employee-paid premium contributions in a group long-term care policy are not tax deductible; however, employer-paid premium contributions in a group policy are not taxable to the employee and are not included in an employee’s annual income, thus lowering the employee’s taxable income.

LTC benefits are received income tax-free by the insured up to the amount of incurred expenses.  Any benefits exceeding the actual costs by the insured are considered taxable, as is the case under a fixed benefit LTC policy when daily benefits payable exceed daily expenses incurred.

Similar to personal excess LTC expenses, if an employee’s annual unreimbursed LTC expenses exceed 10% of his or her adjusted gross annual income (7.5% for individuals born before January 2, 1950), any unreimbursed LTC expenses that exceed this 10% (or 7.5%) are deductible from the employee’s annual income.

Group Disability and AD&D Insurance Premiums and Benefits

Employee-paid premium contributions in a group or franchise disability or AD&D policy are not tax deductible; however, employer-paid premium contributions are not taxable to the employee and are not included in an employee’s annual income, thus lowering the employee’s taxable income.

Employee AD&D benefits are received income tax-free; however, an employee’s disability income (DI) benefits are received income tax-free in proportion to the benefits that represent the employee’s premium contributions.  This means that the employee’s disability income benefits are taxed as income to the employee in proportion to the benefits that represent the employer’s premium contributions to the policy.

As an example, If an employer pays 100% of the group disability insurance premium for its employees (100% employer contribution), then benefits are 100% taxable as income to the employees; if however, the employer pays 50% and the employee pays the other 50% of the premiums, only the portion of benefits that is attributed to the employer’s premium payment is taxable as income to the employee.  Although employees’ premium contributions are not tax deductible from annual income, their 50% paid portion of disability income benefits is received income tax-free.

As a final example, if the employees contribute 100% of the premium payments toward their group disability policy, then 100% of the disability income is received income tax-free for the employees.

FICA Taxation
As is the case with ordinary income, employees are also responsible for paying Social Security FICA taxes on the portion of disability income earned under the DI policy that was funded by the employer’s premium contributions for a 6 month period following the beginning of the DI benefit period, since this portion is considered to be earned income by the employee and would otherwise be taxed as part of the employee’s payroll under FICA.

Group Sponsor Taxation

Employer Taxation
Employer-paid premium contributions for group medical expense, disability and AD&D policies are all deductible as a business expense for the company because they serve as otherwise ordinary income that would be paid to the employee.  Except for cafeteria plans or flexible spending accounts, LTC policies are also deductible as a business expense for the company.

Small business overhead expenses (BOE) are tax deductible as a business expense whether it is a self-employed sole proprietorship, partnership, or corporation.

Self-Employed Taxation
Self-employed individuals, sole proprietors, and partnerships can deduct 100% of their annual unreimbursed medical expenses, however, disability insurance taxation rules apply the same as they do for individual DI policies (taxable premiums and tax-free benefits).

Key Person Taxation
In regards to a ‘key person’ disability income policy or a partnership ‘buy-sell’ disability policy, since the business is providing protection for itself against the loss of one of its key executives or members, the company’s premiums are not tax deductible as a business expense; however, benefits are received income tax-free to the business.

Taxation of Health Spending Accounts

Health Savings Account (HSA)
An HSA is a popular type of medical expense savings account is used both personally, as well as in a group health policy to help control premium costs and to provide better management of an individual’s health needs.   Pre-tax employer contributions, as well as after-tax personal contributions are deposited into the HSA, enabling it to grow tax free just like an ordinary savings account.  Pre-tax contributions are taxable as income upon distribution followed by the reimbursement of any after-tax contributions.

Employer contributions to an employee’s HSA are excluded from an employee’s taxable income, thus lowering the employee’s taxable income.  In addition to the tax-deferred earned interest of an HSA, an insured can withdraw funds from the account on a tax-free basis for ‘qualified’ medical expenses such as unpaid hospital or Medicare expenses, doctor’s fees and prescription costs, as well as other costs outlined in the HSA contract.

Unqualified withdrawals from an HSA before the age of 65 years old are subject to ordinary income taxation, as well as a 20% ‘early withdrawal’ penalty tax.  HSA distributions made once the individual reaches 65 years old are only subject to ordinary income taxation for the year in which they are received by the insured.

Health Reimbursement Account (HRA)
The IRS levies similar taxation on an HRA as it does with an HSA.  Employer contributions to an employee’s HRA are considered to be tax deductible as a business expense for the company because they serve as otherwise ordinary income that would be paid to the employee.

Employee-paid premium contributions in an HRA are not tax deductible; however, employer-paid premium contributions in an HRA are not taxable to the employee and are not included in an employee’s annual income, thus lowering the employee’s taxable income.  Employee benefits received through the HRA are received income tax-free.