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Small Business Employee Benefits and HR Blog

Tax Exclusions vs Tax Deductions vs Tax Credits in Healthcare

January 4, 2013

Several types of tax subsidies for health care costs are embedded in the current structure of the individual income tax.

Tax subsidies can take the form of exclusions, deductions, or credits, each of which has a different structure and different effects on individual income tax liabilities.

Here's a brief overview of the three types of tax subsidies:tax exclusions vs tax deductions vs tax credits

  • A tax exclusion reduces the amount that a tax filer reports as their total, or gross, income.

  • A tax deduction is an expense that is subtracted from total income when calculating taxable income. It reduces tax liability in proportion to an individual’s tax bracket.

  • A tax credit is the direct dollar-for-dollar reduction of an individual’s tax liability. If the tax credit is refundable, individuals can receive its full amount even if they do not have any income tax to offset.

Tax Exclusions

Certain forms of compensation are excluded from taxable income, effectively providing a subsidy for the excluded amount. Some types of income are excluded because they are difficult to measure. Other types of income are excluded to reflect policy choices to encourage taxpayers to engage in a particular activity.

For example, employers’ contributions to 401(k) retirement savings plans are not counted as income for employees, and employees’ contributions are subtracted from their earnings when determining the amount that is reported as taxable.

Similarly, the amounts that employers pay for employees’ health insurance are not counted as taxable income for employees, thus subsidizing the purchase of employment-based health insurance.

Tax Deductions

There are several types of income tax deductions. All taxpayers may subtract certain types of income or expenses—commonly referred to as above-the-line deductions—from total income to derive their adjusted gross income. Those deductions may try to adjust for differences among taxpayers in terms of family or other personal characteristics or to meet other goals of tax and social policy.

For example, people who move more than a specified distance may deduct their moving expenses, and contributions to individual retirement accounts may also qualify (up to an annual limit) for an above-the-line deduction. Similarly, self-employed individuals may deduct the full cost of their health insurance.

Starting from adjusted gross income, taxable income is computed by subtracting personal exemptions and either a standard deduction amount or the total amount of itemized deductions, and it is generally to taxpayers’ advantage to subtract the larger of the two.

In 2012, the standard deduction ranges from $5,950 for single filers to $11,900 for married couples filing jointly. Expenses that are allowed as itemized deductions include property taxes and mortgage interest, state and local income taxes, and charitable contributions; medical expenses not covered by insurance are also allowed, but only to the extent that those expenses exceed 7.5% of adjusted gross income.

The value to taxpayers of allowing itemized deductions for certain expenses thus depends in part on what other expenses they have that can be itemized and how those expenses compare with their standard deduction.

In general, higher-income households are more likely to itemize their deductions, although the
total amount of itemized deductions that can be taken is gradually reduced for taxpayers whose adjusted gross income exceeds $166,800.

Tax liabilities are next determined by applying the statutory tax rates, currently ranging from 10% to 35%, to taxable income. The value of tax exclusions and deductions generally depends on an individual’s marginal tax rate—the rate that applies to the last dollar of income. For example, a self-employed person who is in the 25% tax bracket and deducts the cost of a $5,000 health insurance policy reduces his or her taxes by $1,250; in the 35%bracket, the tax savings is $1,750.

Tax Credits

Tax liabilities can be reduced by tax credits. For example, a portion of the costs that working parents incur for child care can be taken as a tax credit. An important distinction between tax credits, on the one hand, and exclusions and deductions, on the other, is that a tax credit can be designed so that its dollar value does not depend on one’s tax bracket.

Most tax credits are nonrefundable, meaning that the actual credit that taxpayers receive cannot exceed their income tax liability. Because lower-income individuals and families generally owe less in income taxes than those with higher income, they are less likely to benefit from nonrefundable tax credits. Some tax credits are refundable, however, allowing individuals to receive the entire credit amount regardless of their income tax liability.

For example, starting in 2014, individuals and families can take a new premium tax credit to help them purchase health insurance coverage purchased through a Public Individual Insurance Exchange. Exchanges will operate in every state and the District of Columbia. The premium tax credit is refundable so taxpayers who have little or no income tax liability can still benefit.

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