Taxation of Health Coverage Worked

Two questions decide how health coverage is taxed: who paid the premium, and what the benefit replaces. The rules rest on one idea, which is that the treatment of a benefit follows the treatment of the premium that bought it. Dollars that were never taxed produce taxable benefits, and dollars that were already taxed produce tax-free ones. The sections below apply that test to disability income, then compare flexible spending accounts, health reimbursement arrangements and health savings accounts, and finish with long-term care and accidental death and dismemberment benefits. The federal limits on contributions and per diem amounts change every year, so the examples use invented amounts, and a producer sends the client to the current figure and to a tax adviser for advice on a particular return.

The Contribution Test

Gross income includes amounts an employee receives through accident or health insurance to the extent they are attributable to employer contributions that were not included in the employee’s income, or are paid by the employer (IRC 105(a)). Amounts received through accident or health insurance for personal injuries or sickness are otherwise excluded, except to that extent (IRC 104(a)(3)). The employer’s own coverage for an employee under an accident or health plan is generally not income to the employee (IRC 106(a)). Medical expense reimbursements for the medical care of the employee, spouse, dependents and an adult child under 27 are excluded (IRC 105(b)).

A Split-Premium Disability Policy

A group disability income policy costs $200 a month per employee. The employer pays $100 (50 percent). The employee pays $40 (20 percent) through a cafeteria plan by salary reduction, which are pre-tax dollars treated like employer contributions, and $60 (30 percent) from after-tax pay. The employee becomes disabled and receives $2,500 a month.

Share of premium	Who paid and how	Benefit tax result	Monthly amount
50%	Employer	Taxable	$1,250
20%	Employee, pre-tax	Taxable	$500
30%	Employee, after-tax	Tax free	$750

Taxable benefit is 70 percent of $2,500, or $1,750. Tax-free benefit is 30 percent, or $750. If the employee had paid the whole premium after tax, all $2,500 would be tax free. If the employer had paid it all, all would be taxable. A producer can use this to explain why an employee who wants tax-free benefits may choose to pay the premium with after-tax dollars.

FICA and Group Disability Benefits

Income tax is one question and Social Security and Medicare tax (FICA) is another. Payments an employer makes on account of sickness or accident disability under a plan covering employees are generally wages for FICA, and the exception for payments received under a workers’ compensation law is the main one the statute lists (IRC 3121(a)(2)(A)). A second exception removes payments made after the expiration of 6 calendar months following the last calendar month in which the employee worked (IRC 3121(a)(4)).

Suppose an employee last works on March 14. The 6 calendar months following March are April through September, so the period ends September 30. A short-term disability benefit of $2,000 a month paid for April through September is inside the period, for a total of $12,000 that is potentially subject to FICA. A long-term disability benefit that begins October 1 is outside it and is not FICA wages. The long-term benefit may still be income-taxable under the contribution test. The two taxes use different rules. How a given plan’s payments are reported depends on who pays the premium and who pays the benefit, and the payroll department answers that, not the producer.

Comparing FSAs, HRAs and HSAs

Three accounts pay a person’s medical costs from tax-advantaged dollars. They differ in who funds them, who owns them and what happens to money left over.

	Health FSA	HRA	HSA
Who funds it	Employee by salary reduction; employer may also contribute	Employer only	Employee, employer or others
Who owns it	Employer’s plan	Employer’s plan	The individual; it is portable
Health plan required	No	No	A high deductible health plan, and no Medicare enrollment
Unused money	Generally forfeited, with a plan option for a grace period of up to 2 1/2 months or a limited carryover, not both	Carried forward if the plan allows	Stays in the account until used
Self-employed	Not eligible	Not eligible	Eligible, with an HDHP

The facts in the table come from the IRS guide to these accounts. An FSA’s contributions are not subject to federal income or employment tax. HRA reimbursements and distributions from an HSA used for qualified medical expenses are tax free, and money in an HSA grows tax free (IRS Publication 969).

The Use-It-or-Lose-It Cost

Ana elects to put $2,400 into a health FSA for the year. She actually incurs $1,900 of qualified expenses, and the plan has no carryover. Assume an income tax rate of 22 percent, an invented figure, and ignore employment taxes.

• The $2,400 of salary she gave up would have left her $2,400 x 0.78, or $1,872, after tax.
• The FSA let her pay $1,900 of medical costs with pre-tax dollars and forfeit $500.
• She is ahead by $1,900 minus $1,872, or $28.

An overestimate of $500 nearly erased the entire tax advantage. A producer who helps an employee choose an election advises setting it near what is predictable.

An HSA Withdrawal Outside the Rules

Ben, age 40, has a funded HSA and withdraws $600 for a vacation. The amount is included in income. There is also an additional 20 percent tax on the part of distributions not used for qualified medical expenses, with no extra tax on distributions after the owner is disabled, reaches age 65 or dies (IRS Publication 969). At a 22 percent rate, the income tax is $132 and the additional tax is $120, for a total of $252, or 42 percent of the withdrawal.

Long-Term Care and Accident Benefits

Qualified Long-Term Care

A qualified long-term care contract is treated as an accident and health insurance contract, and benefits received under it are treated as amounts received for personal injuries and sickness and as reimbursement of expenses actually incurred for medical care (IRC 7702B(a)(1), (2)). Premiums paid for it count as medical insurance premiums for the medical expense deduction (IRC 7702B(a)(4)). A contract that pays a flat daily amount without regard to costs, a “periodic payment,” is tax free only up to a per diem limitation. The limit is the greater of a dollar amount, which the IRS indexes each year, or the actual cost of qualified services, minus reimbursements (IRC 7702B(d)).

Take an invented limit of $200 a day. A policy pays $250 a day for 30 days, and the actual daily cost is $180. The limitation is the greater of $200 and $180, which is $200. The excess is $250 minus $200, or $50 a day. Over 30 days, $1,500 of the $7,500 paid is taxable. A policy that reimbursed only the $180 would pay entirely tax free.

Accidental Death and Dismemberment

Employer-provided accident coverage is generally not income to the employee (IRC 106(a)). A payment for the permanent loss or loss of use of a member or function of the body is excluded when it is computed with reference to the nature of the injury, without regard to time absent from work (IRC 105(c)). That is how an AD&D dismemberment schedule works: it pays a percentage of the principal sum for the injury, whether or not the insured misses a day of work. The death benefit under such a plan is generally received by the beneficiary free of income tax. That statement describes practice, and a client with a large benefit or an estate question should ask a tax adviser.

Individual Premiums

Premiums an individual pays for a medical or dental policy are not deductible by themselves. They count with other unreimbursed medical and dental expenses toward the deduction allowed for expenses that exceed 7.5 percent of adjusted gross income (IRC 213(a)). A separate rule for the self-employed is outside this lesson. Disability income premiums are not medical expenses, and benefits from an individually owned policy paid for with after-tax dollars are tax free (IRC 104(a)(3)).

Lesson summary

• A benefit’s tax treatment follows the premium: employer-paid or pre-tax premiums produce taxable disability benefits, and after-tax premiums produce tax-free ones (IRC 104(a)(3); IRC 105(a)).
• In a split-premium group policy, the taxable share equals the share of premium paid by the employer or with pre-tax dollars.
• Employer-paid short-term disability benefits are generally FICA wages, while payments made after 6 calendar months following the last month worked are not (IRC 3121(a)(2), (a)(4)).
• A health FSA is use-it-or-lose-it with a limited grace period or carryover, an HRA is funded only by the employer, and an HSA belongs to the individual and requires a high deductible plan.
• HSA money withdrawn for nonmedical use is taxed and carries an additional 20 percent tax, with exceptions at disability, age 65 and death.
• Qualified long-term care benefits are tax free, with per diem payments taxed to the extent they exceed the per diem limitation (IRC 7702B).
• Dismemberment payments computed from the nature of the injury are excluded from income (IRC 105(c)).
• An individual’s medical and dental premiums count toward the medical expense deduction only above the adjusted gross income threshold.