Health reimbursement arrangements (HRAs) enable employers to reimburse employees for premiums and out-of-pocket medical expenses “tax-free.” Customers frequently have questions about what the difference is between categories of health benefits that are tax-free, tax-deferred, and taxable. This article defines them and also discusses some nuances about HRA taxability. .
What is a tax-free health benefit?
With a tax free health benefit, participants pay no taxes on premiums and, often medical expenses paid through the benefit.
The following types of health benefits are tax free:
- Group health insurance premiums
- Reimbursements through a health reimbursement arrangement, like a qualified small employer HRA (QSEHRA) or individual coverage HRA (ICHRA)
- Contributions to a health savings account (HSA)
See IRS publication 15-B for detailed information.
What is a tax-deferred health benefit?
With a tax-deferred health benefit, taxes are not levied until the benefit is used. These benefits are typically account-based, where contributions are made tax free, but taxes only apply to funds when they are withdrawn.
HSAs can be used as a retirement savings vehicle. After the age of 65, people can withdraw money just as they might their 401(k). Withdrawn funds that are not used for medical expenses, must be reported as income. People under the age of 65 can also withdraw funds from an HSA but must pay both income tax and a 20% penalty for early withdrawal.
What is a taxable health benefit?
With a taxable health benefit, an employer simply gives money to employees without any formal arrangement. This is commonly called a “health stipend” and is paid as additional wages, with both payroll taxes and income taxes withheld. While this can seem easy for employers, nondiscrimination rules still apply. If you are offering the money as a health benefit, you must offer the same benefit to all similarly situated employees.
What is the taxability of HRAs?
Group premium payments, HSA contributions are free of payroll taxes and income taxes. HRAs usually are free of both, depending on how employees use their allowance.
How payroll tax saving work in HRAs
Also known as FICA (Federal Insurance Contributions Act) taxes, payroll taxes include deductions for Social Security and Medicare. Typically, the employer pays half (7.65%) and the employee pays half (7.65%), though self-employed people pay both (totaling 15.3%). All reimbursements paid through an HRA are free of payroll taxes for both the employer and the employee.
How income tax savings work in HRAs
The second way HRAs can save taxes is through income tax. To avoid income taxes, an employee must have minimum essential coverage (MEC). When this is the case, all expenses under IRS Publication 502, including premiums are tax deductible.
Employers who reimburse employees through payroll will deduct the amount from gross income (before taxes are applied). Employers who pay reimbursements through cash, check, or ACH will do so directly, and the employee will not need to claim these payments as income for the taxable year.
A few items to note about HRAs and income tax savings:
- MEC coverage obtained from any source (like a spouse’s plan) qualifies an employee’s medical expenses for income tax savings
- However, the employer determines what expenses they will reimburse an employee for. They might choose not reimburse an employee for premiums paid through a spouse’s employer or for all of the expenses listed in the IRS publication 502.
- If the employee does not have MEC or loses MEC during the year, all reimbursements received when they do not have MEC become taxable as income and must be reported as such.
Group health insurance premiums, HSA contributions, and HRA reimbursements are all tax free. While withdrawals from an HSA for medical use are also tax-free, withdrawals for non-medical use are tax-deferred (income tax must be paid for the taxable year when they are withdrawn). Health stipends are fully taxable—while it’s easy for employers to do, it’s also highly inefficient.