Making the Most of Medical Expenses at Tax Time

Healthcare

Health Savings Accounts (HSAs) are tax-deductible savings accounts for paying healthcare costs not covered by insurance. The concept is simple. Your employer buys high-deductible health insurance to cut monthly premiums. Then you or your employer contributes to a deductible savings account for routine medical costs.

You can establish an HSA if you meet four tests:

  • You’re covered by a high deductible health plan (“HDHP”) with deductibles of at least $1,200 (singles) or $2,400 (families) and out-of pocket limits up to $5,950 (singles) or $11,900  (families) (2011). The plan can’t provide any benefit, other than certain preventive care benefits, until the annual deductible is met.  You’re not eligible if you’re covered by a separate plan or rider offering prescription drug benefits before the annual deductible is met.
  • You’re not covered by any plan that isn’t an HDHP, either individually, as a spouse, or as a dependent.
  • You’re not eligible for Medicare.
  • You can’t be claimed as a dependent on anyone else’s return.

Once you’re eligible, you or your corporation can contribute to your account under these rules:

  • You can contribute up to $3,050 (singles) or $6,150 (families). You can make your 2011 contribution any time from January 1, 2011 through April 15, 2012. However, the plan itself must be in place by December 1, 2011 to qualify for deductible contributions in 2011.
  • If you or your spouse is 55 or older, you can make extra “catch up” contributions up to $1,000.
  • You can withdraw funds tax-free for “qualified medical costs.” These include any deductible medical expense or nonprescription drug that isn’t reimbursed by insurance. You can also use HSA funds for qualified long-term care premiums, COBRA continuation coverage, health insurance while you receive unemployment compensation, and Medicare premiums (but not “Medigap” coverage.)
  • Withdrawals for any other purpose are subject to ordinary income tax plus a 20% penalty.
  • At your death, your account balance passes to your chosen beneficiary.  If your spouse is your beneficiary, he/she can treat it as their own HSA.  If not, proceeds are taxed as ordinary income.

Flexible spending accounts (“FSAs”) let you set aside pre-tax dollars for a choice of nontaxable fringe benefits including health and disability insurance, dependent care assistance, and medical expense reimbursement. Plan contributions avoid federal income and FICA tax.

Your employer deducts plan contributions from your paycheck and deposits them into your account until you claim your reimbursements.

When you enroll, you have to choose how much to contribute each pay period. You generally can’t change in the middle of the plan year without a change in your “family status” (marriage or divorce; birth, adoption, or death of a child; spousal employment; change in dependent’s student status; and the like).

You can claim your full year’s reimbursement as soon as you incur qualifying expenses, whether you’ve funded your account or not.

Health Care Costs. You can contribute an unlimited amount to your account and use it for most medical expenses, including prescription medical devices and drugs. However, long-term care coverage, over-the-counter products and expenses are not eligible.

Dependent Care Costs. You can contribute up to $5,000 per year into your dependent care FSA. (If you’re married, the family limit is $5,000 or the lower-paid spouse’s income, whichever is less). You can use your account for “qualified costs” for “qualifying individuals.”Qualified dependents include children under age 13, incapacitated spouses, or any other incapacitated dependent.

Qualified costs outside the home include day-care centers, day camps, nursery schools, or care in the home of a babysitter. Qualified costs inside the home include ordinary domestic services such as laundry, cleaning, and cooking plus Social Security, Medicare, and unemployment taxes (the “nanny tax”) on household employees. You can’t hire your spouse, child, or other dependent as your day-care provider.

Section 125 flexible spending accounts (“FSAs”) let your employees set aside pre-tax dollars for a choice of nontaxable fringe benefits including health and disability insurance, dependent care assistance, and medical expense reimbursement. Here are the rules:

  • By law, employees can contribute unlimited amounts into healthcare FSAs. However, the plan must prescribe either a maximum dollar amount or maximum percentage of compensation that can be contributed.
  • Employees can use accounts for any medical expense, including nonprescription medical devices and drugs,1 so long as they are “qualified costs” for “qualifying individuals.”
  • Employees choose how much to withhold each pay period. They generally can’t change during the plan year unless there’s a change in “family status” (marriage or divorce; birth, adoption, or death of a child; spousal employment; change in dependent’s student status; and the like).
  • Employees can claim their entire year’s reimbursement as soon as they incur qualifying expenses, whether they’ve fully funded their account or not. This leaves you on the hook if employees quit before they finish funding their accounts.
  • Employees can use their accounts for expenses incurred during that plan year only. If they don’t incur enough qualifying expenses during the year, they forfeit the rest of their account. (A new ruling lets you amend your plan to provide a 2½ month grace period immediately following the end of the year.)

Proprietorship, partnership, and LLC plans can include employees but not owners. “S” corporation plans can’t include shareholders who own 2% or more of the corporation, or their spouses. “C” corporation plans can include shareholder-employees; however, they can’t provide more than 25% of deductible benefits to officers earning over $130,000, shareholders owning more than 5% of the corporation, or shareholder employees earning over $150,000 who own more than 1% of the business.

By Dominique Molina, CPA CTC

Dominique Molina is President of the American Institute of Certified Tax Coaches, an organization of tax professionals who are trained to help their clients rescue thousands of dollars in wasted tax. In addition to her blogging and speaking engagements, Dominique provides tax training and CPE for CPAs as a registered educator with the National Association of State Boards of Accountancy (NASBA).

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