As micro businesses set up shop and grow their business, they often look for tax-free ways to pay for health insurance. The most popular route is to set up a tax-preferred premium reimbursement program to reimburse themselves and employees tax-free for individual health insurance.
What is Tax-Preferred Premium Reimbursement?
The concept is simple. The business offers eligible owners* and employees a monthly healthcare allowance to use on individual health insurance – instead of contributing to a group health insurance plan. Employees purchase their own health plan, and are reimbursed tax-free up to the amount available to them.
To receive the tax advantages, the business will set up one of the following:
1. Health Reimbursement Arrangement (HRA) - For 1-Person Plans
For micro businesses with one employee (or one eligible owner), a Health Reimbursement Arrangement, or HRA, is an option. A one-person HRA allows for tax-free reimbursement of health insurance premiums and out-of-pocket medical expenses.
2. Limited Section 105 Medical Reimbursement Plan - For Plans with 2+ Participants
For micro businesses who want to offer tax-free reimbursement to more than one employee or eligible owner, the solution is a limited Section 105 Medical Reimbursement Plan.
A limited Section 105 Medical Reimbursement Plan is similar to an HRA, but is limited to reimbursement of individual health insurance premiums and preventive care services. It also has different rollover rules. The plan is structured in this way to comply with new ACA requirements, whereas the new ACA requirements (aka "Market Reforms") do not apply to one-person HRAs.
*Note: The tax advantages through an HRA or a Section 105 Medical Reimbursement Plan vary for some types of owners. See: Section 105 Plan Eligibility - By Owner Status.
The ROI on Tax-Preferred Premium Reimbursement for Micro Businesses
Micro businesses often evaluate the costs (and savings) of a tax free solution versus giving employees a taxable raise or bonus for their healthcare expenses. There is one major advantage of a tax-preferred plan: cost savings.
Next we'll examine the cost savings for micro businesses when using a tax-preferred premium reimbursement plan versus providing a taxable raise.
Tax Savings to the Business
1. The business pays taxes on a raise. A taxable raise or bonus of $300 per month gross actually costs the business $323 per month after FICA/FUTA payroll taxes (7.65%) are factored in. Annually, the business is spending $3,875 to offer a raise/bonus of $3,600.
2. Tax-preferred reimbursements are tax-deductible to the business. If the small business gives employees a $300 per month allowance, the real cost to the business is $300 (FICA/FUTA payroll taxes do not apply to the reimbursements). Annually, the business is spending $3,600 to offer a pre-tax benefit of $3,600.
Tax Savings to the Owner/Employees
1. Employees pay taxes on a raise. Assuming the employee is 1) single, and 2) making $35,000+, the employee will pay $1,175 of the $3,600 in taxes ($3,600 x 32.65%*). Annually, the business is spending $3,875 to offer an after-tax ("take home") bonus of $2,425.
*Assumes a 25% marginal tax rate + 7.65% FICA/FUTA
2. Tax-preferred reimbursements are 100% tax-free to employees. Because of this, $1 in tax-preferred reimbursement is worth approximately $1.50 - $2.00 in a taxable bonus (depending on the employee's tax bracket). With a tax-preferred plan, the business is then spending $3,600 annually to offer a pre-tax benefit of $3,600, which translates in value to $5,400 - $7,200 in a taxable bonus.
Additional Savings to the Business - Unused Funds Stay with the Business
Lastly, when a business gives a taxable raise or bonus, it's not guaranteed employees will spend the money on healthcare expenses.
With a tax-preferred premium reimbursement program, the business only reimburses for eligible health insurance and medical expenses, within the terms of the plan documents. Employees are only reimbursed once they show proof of their premium expense. And, employees are only reimbursed up to the amount of their allowance.
For example, in the case of a $300 per month allowance, if the employee's health insurance only costs $210 per month, the plan only reimburses $210 per month. The remaining $90 per month stays with the company.
If you're a micro business, what questions do you have about tax-preferred premium reimbursement? Leave a comment below.