Tax Optimizing Health Insurance

How the tax code creates “Cadillac” health insurance plans

For as long as I have been doing taxes I have marveled at the peculiar ways in which federal income tax code treats healthcare and health insurance.

Whether you are employed (W-2) or self-employed (Schedule C), you can pay for health insurance with pre-tax dollars. In IRS terms: Health insurance premiums are fully tax deductible.

In contrast, money you spend on healthcare is an “Itemized Deduction,” which means it comes from post-tax dollars … unless it exceeds the Standard Deduction (which, for 2020 the Standard Deduction is $12,400 per taxpayer), in which case it is pre-income-tax but post-FICA-tax. (And it’s more tax-efficient to keep the Standard Deduction whenever possible.)

The difference between pre-tax and post-tax dollars can be significant: If your marginal income tax rate is 24% then, together with FICA tax (15.3% for 2020), taxes cut each additional $1.00 you earn to just over $.60!

As I described last year: “Health insurance” is not just insurance, but also a tax- and price-advantaged way of buying any covered medical services. Hence the incentive for “Cadillac” health plans, which have low deductibles so that they pay virtually all of your healthcare expenses, instead of only expenses that exceed some catastrophic level. A very-low-deductible health plan can provide net savings for employed taxpayers that expect to spend thousands of dollars a year on routine healthcare.

Amusingly: The Affordable Care Act imposed a 40% “Cadillac tax” on the cost of health plans considered excessive. That tax was delayed and finally repealed in 2019.

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