Tax Provisions for Individuals in the Health Reform Act
The colossal health care legislation, signed into law by President Obama, includes provisions that will affect most individuals, particularly those in the workforce. However, while several items are effective immediately, a variety of mandates, tax increases, and tax credits become effective over the next few years.
“Further tax law changes and modifications to the health care reform law itself are likely to impact tax planning, so it is premature to focus on the Medicare tax hikes coming in 2013 and 2014 and only react to those changes,” says Andy Biebl, a tax principal with LarsonAllen.
Dependent coverage
In the past, employer-provided health coverage was only tax-free if furnished to employees, their spouses, and children who were eligible as tax return dependents. In general, this limited the tax-free health coverage to children under age 19 and those in student status under age 24.
Effective March 30, 2010, the tax-free exclusion is extended to employer-provided health coverage for the child of a taxpayer who has not attained age 27 as of the end of the tax year. This new definition also applies to self-employed taxpayers and S corporation shareholders who claim a deduction for self-employed health insurance premiums. Similarly, employers who offer dependent health insurance coverage are required to change the duration of dependent coverage in their health plans.
Adoption credit increased
Under prior law, a federal tax credit has been allowed for the first $12,170 of qualified adoption expenses (2010 amount). This credit reduced both regular tax and alternative minimum tax (AMT), but if the credit exceeded the current year tax, it was not refundable. Rather, the credit carried forward for the next five tax years.
Effective for 2010 and 2011, the health care reform law increases the adoption credit limit to $13,170. Also, for this two-year period, to the extent the adoption credit exceeds the total tax for the year, the credit is refundable. However, the law does not adjust the high-income phaseout range over which the adoption credit is reduced. That pro-rata phaseout occurs as modified adjusted gross income (AGI) increases from approximately $182,500 to $222,500 (2010 amounts).
Disclosure of health coverage on W-2
Effective with the form W-2 issued for calendar year 2011, businesses are required to add information, identifying the aggregate cost of employer-sponsored health coverage. This reporting includes all employer-sponsored health benefits, such as medical plans, dental plans, vision plans, and self-insured arrangements. Salary-reduction contributions to flexible spending accounts and for employer-paid health savings account (HSA) contributions do not require reporting. The information will have no impact on the employee’s taxable income.
Restriction on over-the-counter drugs in health plans
When an individual claims a medical expense for medications, the deduction is limited to prescribed drugs or insulin. This restriction does not apply to medical care reimbursements from some forms of employer-provided health coverage.
Beginning in 2011, reimbursements from the following categories of health plans are tax free only if a medication expenditure was for a prescribed drug or insulin: employer-provided flexible spending accounts and medical reimbursement plans, health reimbursement arrangements (HRAs), HSAs, and Archer Medical Savings Accounts (MSAs). As a result, an over-the-counter medication qualifies for tax-free reimbursement from these various plans only if it is obtained with a prescription.
Increased penalty on non-qualifying HSA withdrawals
Present law contains a 10 percent penalty if an individual withdraws HSA funds that are not used to pay for qualified medical expenses. Effective in 2011 and after, this penalty increases to 20 percent. A similar adjustment is made to the penalty on non-qualified distributions from an Archer MSA (the precursor to today’s HSAs).
High-income employee Medicare rate
Presently, the Federal Insurance Contributions Act (FICA) employee payroll tax of 7.65 percent consists of two components: 6.2 percent on the first $106,800 of salary for Social Security, and 1.45 percent on all wages for Medicare hospital insurance (HI). This FICA amount is withheld from wages, and the employer must match the amount remitted to the government. Self-employed taxpayers pay the same rates, but must remit both the employer and employee share when filing their Form 1040. Self-employed taxpayers receive an income tax deduction for half of the amount paid.
Effective in 2013, an additional 0.9 percent Medicare HI tax is imposed on the employee share, but only to the extent that an individual’s wages exceed $200,000. Although the 0.9 percent HI increase is on the employee share, the employer is required to withhold the tax and remit it to the IRS. Similarly, the self-employment HI tax is increased by 0.9 percent.
For joint returns, the extra 0.9 percent HI tax is calculated on wages and self-employment income in excess of $250,000, by considering both spouses as one for this computation. Accordingly, if the withholding has been inadequate (e.g., one spouse is over $200,000 of salary with 0.9 percent withholding on the excess, but the other spouse is under $200,000 of wages with no withholding), the additional 0.9 percent HI tax must be remitted via the Form 1040.
Because this extra tax is only on the employee share, a self-employed taxpayer will not be allowed to claim an income tax deduction for the 0.9 percent increase. The self-employed deduction for half of the self-employment tax remains at 7.65 percent.
Medicare surtax on unearned income
In addition to the 0.9 percent Medicare increase on earned income, there is a new 3.8 percent surtax on net investment income of higher income individuals that also becomes effective in 2013. The surtax is 3.8 percent of the lesser of:
- Net investment income, or
- The excess of the taxpayer’s Form 1040 modified AGI over a threshold of $200,000 ($250,000 if married filing jointly).
| Example |
Ted and Beth, joint filers, have $280,000 of salaries and $20,000 of net investment income, reporting $300,000 of AGI in 2013. The 3.8 percent Medicare tax will apply to the entire $20,000 of net investment income, as this amount is less than the $50,000 excess of their $300,000 AGI over the $250,000 joint threshold. If Ted and Beth had $240,000 of salary income and the same $20,000 of net investment income, the 3.8 percent surtax would apply to $10,000 (excess of $260,000 of AGI over $250,000 threshold).
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Net investment income includes interest, dividends, annuities, royalties, and rents. It also includes passive income (from a business in which the taxpayer does not personally materially participate) and business income from trading in financial instruments or commodities. Capital gains and other net gains from the disposition of property are also included, except to the extent attributable to the sale of an active interest in a business.
There are a number of exceptions to the definition of net investment income. Active business income is excluded, as well as interest income and other working capital income attributable to an active business ownership. Qualified retirement plan and IRA distributions are excluded, and any self-employment income is exempt. Finally, tax-exempt interest income and other nontaxable gains, such as from the sale of a principal residence, are not considered investment income for this surtax.
Biebl notes that this surtax will require a complex side calculation in upper income 1040s, but also that some may be able to minimize its impact. “For those whose total income is near the $200,000 or $250,000 surtax threshold, the focus will be on strategies to stay beneath. For those well above the threshold, we’ll recommend shifts into investments that avoid the surtax or that defer investment income to years of lower AGI.”
Estates and trusts are also subject to the 3.8 percent surtax. The tax applies to the net investment income of the entity, but this income is limited to the excess of estate or trust AGI above a threshold amount (currently $11,200 in 2010). The definition of estate and trust AGI allows a subtraction for distributions of income to beneficiaries.
“The income of estates and trusts is typically entirely from investment sources and will be subject to this new surtax,” says Biebl. “It will become more important to move that income out to the beneficiaries through distributions, to keep the trust or estate share beneath the threshold of the 3.8 percent surtax.”
Increased threshold for deducting medical expenses
Presently, medical expenses are only allowable as an itemized deduction on the Form 1040 to the extent they exceed 7.5 percent of the taxpayer’s AGI. But beginning in 2013, this threshold increases to 10 percent of AGI.
| Example |
| A taxpayer with AGI of $100,000 currently receives no deduction for unreimbursed medical costs and medical insurance unless those expenses exceed $7,500. Beginning in 2013, the threshold to achieve deductibility rises to $10,000 for a taxpayer with $100,000 of income. |
However, if either the taxpayer or spouse turns 65 by year-end, this increase to 10 percent of AGI is not effective until 2017. When fully implemented, the 10 percent floor will be the same in the regular tax system as under the present AMT rule.
Contribution cap on flexible spending accounts (FSAs)
Presently, the tax law does not place a dollar limit on the amount that an employer’s cafeteria plan permits employees to salary-reduce annually into their health FSAs. Beginning in 2013, this law puts a cap of $2,500 on the amount an employee can annually contribute into a health FSA. This amount will be inflation indexed after 2013.
Individual penalty for failure to maintain health insurance
Beginning in 2014, the law imposes a penalty on any individual who fails to maintain “minimum essential coverage” for health care. When fully phased in by 2016, the penalty is the greater of:
- 2.5 percent of the taxpayer’s household income over the threshold for filing a 1040 for that year, or
- $695 per uninsured adult plus half of that amount per uninsured child under age 18, but capped at $2,085 per household
During the 2014–2015 phase-in period, the penalty is 1 percent of household income for 2014 and 2 percent for 2015. The per-uninsured penalty is $95 for 2014 and $325 for 2015, and half those amounts per uninsured under 18.
There is an overall limit on the penalty, equal to the national average premium for the “bronze level” of health insurance offered through the insurance exchange for the family size (“bronze” refers to coverage that is actuarially equivalent to 60 percent of full coverage).
The penalty will be included with the Form 1040. But the IRS may not impose interest on any late payment, nor is the failure to pay subject to criminal prosecution or assessment, and the IRS may not file a lien or levy on the property of the taxpayer.
To avoid the penalty, an individual must maintain “minimum essential health care coverage” under one of the following:
- Medicare, Medicaid, TRICARE, veterans’ care, or other governmental programs
- An employer-sponsored group plan that is either a governmental plan or any other offered in the group market within the state
- A grandfathered health plan, based on an individual’s right to maintain existing coverage
- Any other coverage, such as a state health risk pool, recognized by the Department of Health and Human Services
There are exemptions to the penalty for individuals whose income indicates they cannot afford coverage (defined as a required health care premium exceeding 8 percent of household income) and those with income below the tax return filing threshold. Members of Indian tribes and those with coverage gaps less than three months are also exempt.
Employer health insurance coverage mandate
Beginning in 2014, employers with at least 50 full-time employees or full-time equivalents will face a nondeductible excise tax if any of their full-time employees receive federal subsidies, such as the new premium assistance tax credit or cost-sharing reductions. The penalty is assessed differently depending upon whether an employer offers employees health insurance that meets the definition of “minimum essential coverage” (defined as affordable based on employee income and for which the plan covers 60 percent or more of the total costs of the benefits provided). For employers providing no coverage, the excise tax is $2,000 per full-time employee annually (excluding the first 30 full-time employees).
For employers offering minimum essential coverage, the excise tax is the lesser of $3,000 per full-time employee receiving federal subsidies or $2,000 per full-time employee annually (excluding the first 30 full-time employees). This calculation excludes those employees who are eligible for and receive a “free choice” voucher from the employer. Also, some employers offering minimal essential coverage, regardless of company size, will be required to offer these vouchers to certain employees.
A “free choice” voucher is equal to the value of the employer’s largest contribution to the employer-offered health plan, and is used by the employee to purchase coverage through a state-sponsored insurance exchange. Employees are eligible to receive vouchers if they meet the following conditions:
- They do not participate in the employer plan
- The required contribution for minimum health coverage is between 8 percent and 9.8 percent of household income
- The household income is not greater than 400 percent of the federal poverty level (FPL) for their family size. (The 400 percent FPL figure for a family of four is currently $88,200.)
The vouchers are tax free to the extent an individual uses the voucher for health care premiums. Voucher recipients are ineligible for the federally subsidized premium assistance tax credit and cost-sharing reductions.
Low-income tax credit for insurance exchange participation
The law adds a new refundable premium assistance tax credit for lower income individuals who purchase their health insurance through a state-sponsored insurance exchange. The credit is available to those with incomes up to 400 percent of FPL (currently $43,320 for an individual and $88,200 for a family of four) and will be paid monthly to the health insurance provider.
The credit is based on a sliding scale, comparing the taxpayer’s household income to the federal poverty level. As income increases, the taxpayers are expected to devote a greater percentage of their incomes to the health care premium. The taxpayer’s share ranges from 2 percent to 9.5 percent of household income, with the tax credit filling the gap.
| Example |
| Assume a single individual has an annual household income of $27,000, which is currently near 250 percent of FPL. Based on the sliding scale credit, the government subsidizes health insurance costs of more than 8 percent of income or, in this case, $2,160. The insurance cost is set by reference to the second lowest cost plan (“silver plan”) in the insurance exchange rating area where the taxpayer resides. For example, if the premium cost was $5,000, the taxpayer’s credit would be $2,840 ($5,000 less $2,160). The credit is limited to the actual premium that the taxpayer is required to remit for the particular health coverage and is reconciled in his/her return at year-end. |
The big picture on tax rates for upper-income filers
Further tax law changes and modifications to the health care reform law itself are likely to impact tax planning, so it is premature to focus on the Medicare tax hikes coming in 2013 or 2014 and only react to those changes.
“That ignores the larger increases in the basic tax rates that are likely to hit in 2011,” says Biebl.
The Obama administration’s budget calls for taking the present top 1040 rate from 35 percent to 39.6 percent and bringing back the phaseout of personal exemptions and itemized deductions. This will push the top rate in 2011 to roughly 42 percent, and this is the same group that is being taxed to help fund health care reform (single filers over $200,000 and joint filers over $250,000).
“To come up with an effective tax strategy, the two sets of rate hikes need to be seen as one,” says Biebl.
When these Medicare tax hikes arrive in 2013, those with high salary or self-employment income paying the 0.9 percent will be at roughly a 43 percent top rate, and those with investment income incurring the 3.8 percent surtax will reach about 46 percent. “Those are the rates we need to consider in looking at alternative business entities and investments,” according to Biebl. “We need to consider the big picture.”
Helpful health care reform resources
For more information, contact a tax principal in your region.