Individual Policies
Generally, premiums paid to fund individual health insurance policies are not tax deductible. There are 2 exceptions:
- 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.
- Sole proprietors and partners in business can deduct the full amount paid (100% of the premiums) for all types of health insurance for themselves, their spouses, and dependent children.
Health insurance benefit payments, including disability income benefits received from an individual policy, are tax-free.
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 or disability buy-out, but can exclude any benefits received from its gross taxable income.
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 is deductible as a business expense and benefits received are tax-free.
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
Taxability of the 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 business partners can deduct 100% of health insurance premiums for themselves, their spouses, and dependent children.
- Health insurance benefit payments, including those from individual policies, are typically tax-free.
Regarding business policies:
- A company cannot deduct premiums for certain insurances but can exclude benefits from taxable income.
- Business overhead expense insurance is both deductible and benefits received are tax-free.
- 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.
