The IRS allows employers to offer medical savings accounts that accept pretax contributions from employees. This offers a deduction to income and significant savings on your annual tax bill. As of 2012 the IRS also offered the Health Coverage Tax Credit, which allows qualified taxpayers to credit a portion of their after-tax health insurance premiums against their tax bills.
If you buy health insurance on your own, you pay with after-tax dollars. The money with which you pay the premiums is subject to federal and state income tax. Health-insurance premiums on their own are not deductible, although total medical expenses (including premiums) above 7.5 percent of your gross income may be declared as an itemized deduction on the federal return. If you are qualified for the Health Coverage Tax Credit, you may subtract 72.5 percent of your premiums (in 2012) from your tax liability. To qualify, you must be receiving Trade Adjustment Assistance benefits, or pension benefits from the Pension Benefit Guaranty Corporation, or be the spouse or dependent of someone who qualifies.
The IRS does allow qualified employer-sponsored health savings accounts -- which are available if you have a high-deductible medical policy -- or flexible spending arrangements to accept pretax contributions. The HSA contribution charged to you as an employee is deducted from your salary before federal and state tax withholding are figured on the gross wages. If you participate in an FSA, which you use to pay out-of-pocket medical expenses, then the contributions are also made with pretax income. This means that the portion of your expenses related to health insurance are deductible; if you are in the 15 percent marginal tax bracket, you save 15 percent of the premium or expense amount.
Tax Penalty Considerations
Pretax HSAs come with conditions, including the important rule that you must spend any money in the account on medical expenses. If you withdraw money for a non-medical expense, the IRS levies a 20 percent penalty on the withdrawal and also requires that you add it to your taxable income for the year. This would negate most or all of any tax advantage the pretax contribution has over an after-tax premium. Also, it's good to note that HSA and FSA dollars cannot be used for over-the-counter drugs, unless your doctor prescribes them.
Qualifying Status Change
Pretax medical accounts, such as a flexible spending arrangement, limit your ability to make changes in the coverage. Every year, employers will set an open enrollment period, a short window of time in which you can add or subtract individuals from the policy or enroll in a new one. In addition, there is a "run out" period at the end of the year in which you must submit any claims to be paid out of the FSA. When the run-out period ends, you forfeit any money left in the account. As of 2013, the maximum annual contribution to an FSA stood at $2,500.
Founder/president of the innovative reference publisher The Archive LLC, Tom Streissguth has been a self-employed business owner, independent bookseller and freelance author in the school/library market. Holding a bachelor's degree from Yale, Streissguth has published more than 100 works of history, biography, current affairs and geography for young readers.