Savvy employers and consumers can take advantage of several types of tax reductions when it comes to healthcare costs.
Tax reductions 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:
- 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 a 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.
Learn how a health reimbursement arrangement (HRA) lets employers give employees tax-free money for insurance premiums and out-of-pocket medical expenses.
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 not included in their earnings when determining taxable income. These amounts are also exempt from payroll tax (aka FICA).
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.
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. These deductions may differ among taxpayers based on family status or other personal situations 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 for an above-the-line deduction. Similarly, self-employed individuals may deduct the full cost of their health insurance from their income.
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 2017 the Tax Cuts and Jobs Act nearly doubled the standard deduction to simplify filing for many households who would take this deduction instead of itemizing deductions. For the 2019 tax year, the standard deduction ranged from $12,200 for single filers to $11,900 for heads of household filing jointly.
Those who can deduct more than the standard deduction should do so. 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.
Tax liabilities are next determined by determining which tax bracket you fall into based on the taxable income after these deductions. These rates range from 10% to 37%. 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 24% tax bracket and deducts the cost of a $5,000 health insurance policy reduces his or her taxes by $1,200; in the 35% bracket, the tax savings is $1,750.
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, individuals and families that fall between 100% and 400% of the Federal Poverty Line can receive a premium tax credit to help them purchase a Qualified Health Plan (QHP). The premium tax credit is refundable so taxpayers who have little or no income tax liability can still benefit.
Consumers can save significant money on their taxes if they understand the ways in which they can exclude, deduct, or receive credits for medical expenses. We recommend you consult your tax or financial advisor to understand how.
Learn the difference between key tax-savings vehicles by downloading this comparison chart: HRA vs. HSA vs. FSA.
This post was originally published on January 4, 2013. It was last updated on December 21, 2020.