It is that time of year! No, not the holiday season, open enrollment and health insurance exchange renewal season. This year many of us are being faced with large increases in our health insurance costs along with the loss of some key benefits. You may be asking yourself what you can do to help with the costs of yours and your family’s health care. While there are some things we can’t control (like the rates of the health insurance market), one thing you can do is to make sure you are actively maximize the tax deductions related to your health care costs.
There are a number of options available to you – let’s take a look at the most common options and the pros and cons of each one.
The first reason that this option is not very favorable is that you are only allowed to deduct the expenses that are more than 10% of your adjusted gross income. Let’s say for example that you make $50,000 per year, you would need to have more than $5000 of medical expenses before you would receive a deduction. Additionally, you can only write off the amount that is more than 10% – so in this example if you had $6000 of expenses, you would only be able to deduct $1000 of your medical expenses for the year.
The second limitation to this write off is that it is an itemized deduction. Which means that unless you have enough other deductions such as mortgage interest, real estate taxes and charitable contributions to itemize on your return there is no benefit at all. For example in 2016 you would need more than $6300 if you file single and $12,600 if you are married filing jointly in itemized deductions to receive any benefit for your medical expenses that do exceed 10% of your income.
2. A second option is the Flexible Spending Account. A flexible spending account is also referred to as a FSA, cafeteria plan or 125 plan. These accounts are the most common options currently available through employers. With a FSA you can set aside up to $2550 in funds that you can use tax free during the year for health care expenses. You must decide at the beginning of the year how much to set aside and the funds are “use it or lose it”, meaning that if you don’t spend them by year end you forfeit the funds. This often scares people away from FSA plans – don’t let it! While there is a certain unpredictability component to our health care spending each year, there are also certain things you know you will spend each year. Maybe you know you will have 2 dental cleanings, 2 child well checks, and a monthly prescription to pay for. In this case there is no reason not to set aside at least enough to cover these costs. Every dollar that you set aside in a FSA through your employer comes out pre-tax for both employment and income taxes so you have an immediate benefit even if you are in a low income tax bracket.
3. A third option is a Health Savings Account or HSA. HSA plans were first introduced in 2003, but have become more popular over the last few years as many of us have moved to high deductible health plans in order to save on our health insurance premiums. The only requirement of an HSA is that in order to participate in and HSA you must be a participant in a high deductible health plan. To participate in a FSA your employer must offer the plan, but that is not the case with an HSA, it can be either employer sponsored or you can sign up for an individual HSA account. An HSA offers triple tax benefits. It allows you to set aside funds pre-tax for health care spending, but unlike a FSA the HSA funds roll over if they are not used. Additionally, these funds are able to grow tax free (similar to a Roth IRA). For 2017 the contributions limits to a HSA are $3400 for an individual and $6750 for a family. Many employers will also make matching contributions into your HSA account which represents another immediate tax free health benefit. HSA accounts are not tied to your employer, and if you leave the company your HSA comes with you and can be used for any medical purpose in the future.
HSA accounts allow you to take control of your health care spending. For example, if I know that in two years I am going to have to pay for braces for a teenage child, I can start putting tax free dollars into my HSA account today. These funds can earn interest and grow tax free for the next two years. Once my teenager is ready for his braces, I now have funds in my account that I can use to pay up front for the braces. Since many providers will offer a discount if you pay up front, I now was just able to pay for braces tax free and at a significant discount without having to hurt the family budget.
Depending on your employer, you may be able to get the best of both worlds if you have the option of a limited flex spending plan. With this option you are able to participate in a HSA for your general medical expenses, and a FSA for any items that are outside your health care plan. Generally this would include items such as dental and vision. The same “use it or lose it” rules apply to the FSA portion of this option, so make sure to keep that in mind as your incur your expenses during the year.
Setting aside tax free funds for your health care costs is a financially savvy move. However, with the various options available it can be confusing and overwhelming. Often employers give you only a few days to make your FSA or HSA elections at year end. Don’t let this deter you from doing something! Tax free health care spending has never been easier! Take some time before you get the open enrollment notice to check out your options, estimate your upcoming and potential expenses and you will be prepared and confident when it comes time to choose a health care spending plan that will best benefit you!