Health Insurance Taxation

Individual Policies

Generally, premiums paid to fund individual health insurance policies are not tax deductible. There are 2 exceptions:

1. If the sum of premiums paid for medical expense insurance, premiums paid for LTC insurance, and out-of-pocket medical expenses exceeds 7.5% of one’s adjusted gross income (AGI), they are deductible only to the extent that they exceed 7.5% of AGI.
2. Sole proprietors and partners can deduct 100% of the premiums for qualifying medical and hospital insurance. For long-term care insurance, premiums are deductible only up to the annual age-based limits set by the IRS.

Premiums for disability income insurance are not considered health insurance expenses for tax purposes and are not deductible. If you purchase an individual disability income policy and pay the premiums with after-tax dollars, the premiums are not deductible — but any benefits received are tax-free. If your employer pays the premiums or you use pre-tax dollars (such as through a cafeteria plan), the premiums are not taxed to you, but any disability income benefits you receive will be included in your taxable income. If the cost of the policy is shared between you and your employer, then the taxable portion of the benefits will match the percentage of the premium that was paid with pre-tax dollars.

Business Policies

A company cannot deduct the premiums paid for key person, executive bonus insurance, or insurance purchased on the lives of the business owners to fund a buy/sell agreement.

However, death benefits received from life insurance used to fund a buy/sell agreement are generally excluded from the company’s gross taxable income.

Premiums for a disability buy-out policy are also not deductible, but benefits may or may not be taxable depending on the ownership structure and how the policy is funded.

For example, if a partner receives a lump sum from a disability buy-out policy, the tax treatment depends on who paid the premiums and how the policy was structured.

If a disabled partner receives more from a disability income insurance policy than is required to fund a buy-sell agreement, the excess is taxable as ordinary income to the disabled partner.

Business overhead expense insurance premiums are tax-deductible as a business expense. Benefits received under the policy are generally considered taxable income to the business, but since they are used to cover deductible operating costs (such as rent, utilities, and employee salaries), the net tax impact is usually neutral.

Premiums paid to fund group health insurance plans are tax-deductible by the employer. Generally, employees covered under a group health plan are not taxed on benefits received from group insurance. There is one exception:

Disability income payments received by an employee from an employer-paid group disability income policy are included in the employee’s gross taxable income, that is to say the benefit is taxable.

Note: If the employer offers contributory group disability insurance, only the portion (percentage-wise) paid by the employer is taxable. The logic behind this is that the employer’s portion of the premium is tax deductible (pre-tax), while the employee pays their portion of the premium with money that has already been taxed.

Here’s an example showing how disability income insurance benefits from an employer-sponsored group policy would be taxed when the employee pays 30% of the premium:

Total monthly premium for the disability insurance: $100

Employee pays 30%, or $30/month, using after-tax dollars

Employer pays 70%, or $70/month

The employee becomes disabled and starts receiving $3,000/month in disability benefits

The taxability of the benefits depends on who paid the premium and whether it was paid with pre-tax or after-tax dollars:

Employer-paid portion (70%): Taxable

Employee-paid portion (30%) with after-tax dollars: Not taxable

How to Calculate the Taxable Portion: Since the employer paid 70% of the premium, 70% of the monthly disability benefit is taxable, and 30% is tax-free.

Taxable amount: 70% of $3,000 = $2,100

Tax-free amount: 30% of $3,000 = $900

The employee would pay income tax on $2,100/month, and $900/month would be received tax-free.

Lesson Summary

When it comes to health insurance, there are tax considerations to keep in mind:

• Premiums paid for individual health insurance policies are usually not tax deductible.
• Exceptions to this rule are:
  • If the sum of certain medical expenses exceeds 7.5% of one’s adjusted gross income (AGI), they are deductible beyond that threshold.
  • Sole proprietors and partners can deduct 100% of the premiums for qualifying medical and hospital insurance. For long-term care insurance, premiums are deductible only up to the annual age-based limits set by the IRS. Premiums for disability income insurance are not considered health insurance expenses for tax purposes and are therefore not deductible.
• Health insurance benefit payments — such as those from medical, hospital, and long-term care policies — are typically tax-free. Disability income insurance benefits, however, are only tax-free when the policy is individually owned and the premiums were paid using after-tax dollars.

Regarding business policies:

• A company cannot deduct premiums for certain insurances but can exclude benefits from taxable income.
• Business overhead expense insurance: Premiums are deductible, and although benefits are taxable to the business, the net tax effect is typically neutral due to the deductibility of covered expenses.
• Group health insurance plans provide tax benefits:
  • Employers can deduct premiums paid.
  • Employees covered under a group health plan are usually not taxed on benefits received.
  • An exception exists for disability income payments from employer-paid group disability plans, which are taxable to the employee.