Financial Abundance

Years ago, most of us had such wonderful health insurance coverage that we never considered keeping track of medical expenses for tax deductions, as medical expenses were never above 7.5% of Adjusted Gross Income (AGI).  However, for many of us, those days are only fond memories.

For at least the next two tax years, the AGI medical deductible hurdle of 7.5% will remain in place.  Even if you make over $100K per year, you may find that keeping track of your medical expenses will help lower you’re the amount you pay in taxes.  Let’s look at some deductible medical expenses of which you might not even be aware:

1. Medically related travel: Whenever you must travel to a doctor’s appointment by car, for 2011, the IRS allows a mileage deduction of $.19 from January through June and $.235 for July through December.  If you must fly to an out-of-town clinic, the full cost of your flight plus a per diem allowance of $50 per person per day is deductible.

2. Medical Insurance Payments, including long term Care Insurance: If you pay for your own medical insurance, the premiums paid are fully deductible.  If you pay for long term care insurance, the premiums are deductible up to a maximum amount based on your age at the end of the tax year.  The maximum deductible amounts for long term insurance premiums are: Age 40 or less $340; Age 41 through age 50 $640; Age 51 through age 60 $1,270; Age 61 through age 70 $3,390; Age 71 or older $4,240.

3.  Uninsured medical treatments: This includes what you spend for an extra pair of eyeglasses or on contact lenses, false teeth, hearing aids or artificial limbs.

4. Rehab treatment for drug, alcohol, or any other recognized addictive disorder: This includes amounts you pay for an inpatient’s treatment at a therapeutic center for alcohol or other addictions, including meals and lodging provided by the center during treatment. You can even include amounts you pay for transportation to and from 12 Step meeting, if the attendance is pursuant to medical advice that membership is necessary for the treatment of a disease.

5. Weight-loss, smoking cessation and other health related issues: If a doctor prescribes it, you can deduct it.

6. Laser vision correction surgery: These surgeries are allowable expenses to deduct on your taxes

7. Doctor-recommended equipment and related expenses: If your doctor tells you that you need a humidifier installed on your heating and air conditioning system to aid your breathing problems, you may be able to deduct the full amount of this home improvement.

8. Home improvements or equipment: If you do a home improvement or bring in special equipment that’s considered medically necessary, for you, your spouse or your dependents, you may deduct the cost of this equipment and it’s installation. This may include special entrance/exit ramps, widening doorways, modifying kitchens or bathrooms, or adding a chairlift   If the improvement increases the value of your home, only the amount of the expense that exceeds the increase in the property value of your home is deductible.

9. Medical education costs: If you, your spouse or a dependent have a chronic medical condition and you attend a conference related to this condition, your conference admission and transportation expenses are deductible.  However, meals and lodging are not deductible.

10. Out-of-town treatment for a dependent: When accompanying a minor dependent to out-of-town medical treatment, your hotel bills will likely be at least partially deductible.

11. Nursing services: Out-of-pocket payments for a home-based nurse are fully deductible,

12. Lead paint removal: If your house has any lead paint, the full cost of lead paint removal is deductible.

13. Medical Insurance payments by the self-employed: If you are self employed, the full cost of your family’s medical insurance premiums are deducted, as an adjustment to gross income.  This payment is not subject to the 7.5% deduction hurdle, but is a direct deduction from gross income.

From this non-exhaustive list, it is obvious why it is not too difficult for medical expenses to exceed 7.5% of AGI.  Unfortunately The AGI hurdle is set to increase to 10% in 2013 under the Patient Protection and Affordable Care Act (PPACA) passed in 2010.

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In March of 2010, the Patient Protection and Affordable Care Act (PPACA) was passed by Congress and signed by the President.  In spite of its lofty title, this act includes several “features” that will raise the amount of taxes we pay on medical related services, regardless of your income bracket.

It has always seemed inequitable to me that we may deduct 100% of our mortgage interest payments from federal income taxes, but are only allowed to deduct medical expenses that exceed 7.5% of our Adjusted Gross Income (AGI).  From this inequity, we must  assume that our government places a higher priority on buying a house than it does on medical expenses.

When PPACA was first introduced, I assumed that it would address this inequity by  eliminating the 7.5% AGI deduction hurdle on medical expenses.  This would definitely provide “more affordable (medical) care,” much like the home mortgage deduction makes home ownership more affordable. However, I was shocked to see that PPACA not only does not remove the 7.5% tax hurdle, it makes medical treatment more expensive by raising the AGI threshold hurdle to 10%.

This medical tax increase hurts the middle class much more than the wealthy, as very few tax payers, whose AGI exceeds $200K, can claim a medical deduction.

Consider a couple with $70K AGI that has $7,000 in medical bills.  Under current tax law, this couple could deduct $1,750 in medical expenses from their federal income taxes.  However, staring in 2013, PPACA will reduce their in medical deductions to $0, while they will still be able to deduct 100% of their home mortgage interest payments.

Another area where PPACA increases the middle class’ medical costs is through its reduction of Flexible Spending Account (FSA) medical contributions.  Under current law, you may contribute up to $5,000 each year to an FSA, to pay for medical expenses that are not covered by insurance.  The $5,000 FSA contribution is directly deducted from your income, meaning that it is fully tax free, including FICA taxes.

A single person in the 25% federal tax bracket (AGI exceeds $34,000), with state income taxes of 5%, has combined federal, state and FICA taxes of 37.65%.  This represents $1,882 in total taxes on $5,000 of income.  By putting $5,000 into an FSA, they save $1,882, as long as they have at least $5,000 in uncovered medical expenses during the year.

Starting in 2013, PPACA lowers the maximum amount that can be contributed to an FSA to $2,500, cutting the tax saving for a medical FSA in half.  The relatively low income person shown above will pay an additional $941 in taxes, thanks to PPACA.

For higher income taxpayers, PPACA has additional Medicare taxes.  Starting in 2013, single taxpayers earning over $200K and couples earning over $250K per year will be pay an additional 0.9% in Medicare taxes on income that exceeds these limits.

Another Medicare tax is the new 3.8% “unearned” income tax on single taxpayers with an AGI exceeding $200K and couples with an AGI exceeding $250K.  Virtually any income that does not come from employment will be subject to this tax.

As an example, consider a couple with an AGI of $300K, of which $200K comes from their joint earned income and $100K comes from royalties, rents, annuity distributions, capital gains and dividends.  $50K of their income would be subject to the 3.8% Medicare tax, increasing their tax bill by $1,900.

It can always be debated whether the “wealthy” are paying their fair share of taxes.  Thus, the PPACA provisions that require higher income individuals to pay more in taxes are open to political debate.

However, it seems unconscionable for an act that is supposed to make health care more affordable, to increase the price of health care on the middle class.  The PPACA has already been modified to remove the $600, 1099 reporting requirement.  Perhaps it is now time to help our government understand that 1) medical expenses should have at least the same deductibility as home mortgage interest payments and 2) FSAs are good for people of all income brackets, so leave them alone.

Medical costs continue to sky rocket.  The last thing that we need is to increase the taxes that everyone must pay on these expenses.

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The Patient Protection and Affordable Care Act (PPACA), commonly called Obamacare, has altered much of the traditional health insurance landscape.  One health insurance plan that has remained virtually unchanged is the High Deductible Health Plan (HDHP), which can be combined with a Health Savings Account (HSA.)

The only modifications that PPACA made to HSAs were to:

1. Restrict the use of tax-free dollars to purchase over-the-counter drugs not prescribed by a doctor and,
2. Increase the tax on HSA distributions that are not used for qualified medical expenses from 10% to 20%.

It is important to understand that an HSA receives better tax treatment than any other savings approach.  Annual contributions to an HSA are fully deductible in the tax year in which the contribution is made, just like an IRA.  What makes an HSA unique is that all of the funds contributed plus all of the growth and income from an HSA can be withdrawn tax free to pay for qualified health care expenses, just like a Roth IRA.  An HSA is the only investment vehicle which receives both immediate tax deductibility and tax free withdrawals, as long as the funds as are used to pay for qualified health care expenses.

When HSAs are fully funded each year, the combination of lower cost health insurance through an HDHP with the generous tax treatment of an HSA, should make this approach to health insurance a virtual “no-brainer” for many people. If your family’s taxable income is above $68,000 (the beginning of the 25% marginal federal income tax bracket) and you contribute the family maximum of $6,150 to an HSA, the after tax cost of an HDHP will be always be less than a the cost of a traditional health insurance plan.

If a traditional health insurance family plan costs $400 per month, the High Deductible Health Plan will cost approximately 20% less or $320 per month.  The HDHP appears to save only $80 per month or $960 per year.  If the traditional health plan has an annual deductible of $1,000 and the HDHP has a $3,000 deductible, the $960 yearly savings may not be worth the risk of possibly paying $2,000 more in deductible expenses.  This is true, until we consider the after tax cost of an HDHP/HSA combination.

Since tax free HSA funds can be used to pay the medical expenses required for the HDHP’s deductible, the “before tax” deductible cost is the same as the “after tax” deductible cost of $3,000.  With the traditional plan, medical expenses are paid with after tax dollars.  Thus, if a person is in the 25% federal income tax bracket, a $1,000 deductible actually requires $1,333 in pretax dollars. On a pretax basis, the difference in deductibles is $1,667, not $2,000. Thus, the traditional plan, costing $960 more would provide a maximum “savings” of ($1,667 – $960) = $707.

When an HSA is fully funded, the savings by using an HDHP become significant.  For a family with taxable income over $68,000, a $6,150 HSA deposit will provide an immediate federal income tax savings of at least ($6,150 *25%) = $1,537.50.  By including the HSA contributions income tax savings, the HDHP plan costs $830.50 less ($1,537.50– $707) than the traditional plan.   And this is in a “worst case” scenario, where the annual health care costs exceed the $3,000 deductible.  If annual medical expenses are only $1,000, the HDHP/HSA combination would cost $2,830.50 less than a traditional plan.

If you are in a higher federal tax bracket or if you pay state income taxes, the HDHP/HSA savings are even greater.  Plus, HSA funds that are not required for immediate health care expenses can continue to grow in the HSA, on a totally tax free basis, until they are eventually withdrawn for qualified medical expenses.

If your family taxable income exceeds $68,000 and you have an HDHP available, choose the HDHP and fully fund the HSA.  Your financial advisor can provide a personal financial analysis to demonstrate what you will save with an HDHP/HSA combination health plan.

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In 2011, the leading edge of the “Baby Boomer” generation reaches age 65, while the average American life span continues to rise.  The confluence of these two phenomena will dramatically increase the number of Americans who will ultimately require long term care.  With the national average annual cost of nursing home care exceeding $78,000, many are considering how to fund long term care (LTC).  Let’s look at some strategies for funding potential LTC requirements.

Long Term Care insurance typically pays a maximum daily amount for either in home care or nursing home care, after an elimination (waiting) period of either 90 or 180 days.  LTC insurance policies are a popular method of protecting against catastrophic long term care expenses.  However, depending upon the age at which you initiate the LTC insurance, policies will often have premium costs between $2,000 – $6,000 annually.  Like any insurance policy, these payments could be very worthwhile if LTC is required, but are lost if LTC is never needed.

Beginning in 2010, the 2006 Pension Protection Act provides new methods in which LTC insurance can be funded.  Some “hybrid” whole life insurance policies are combined with LTC coverage.  With these policies, a portion of the death benefit can be paid out before death, to cover the insured’s LTC expenses.  “Hybrid” deferred fixed annuities can also be packaged with LTC benefits.  Starting this year, any LTC benefits that are received from either of these “hybrid” products are tax free, providing considerably higher after tax benefits for most recipients.

A current whole life insurance policy or deferred annuity may also be utilized when purchasing a new “hybrid” policy, through a nontaxable exchange under IRC Section 1035.  If the “hybrid” product insurer provides for a 1035 exchange, you may “convert” a current life insurance or annuity policy to a “hybrid” policy.  The “hybrid” policy will allow for  insurance proceeds, used to pay for long term care, to be received on a tax free basis.

Another way to pay for long term care is to “self insure.”  Insurance products are best when used to protect against financially catastrophic events.  If you have adequate financial resources, you may wish “self insure” for long term care requirements.  Let’s see how self insurance works.

Jane is a single 85 year old, with $300K in retirement funds and other investments.  She also owns a mortgage free home valued at $300K.  To meet her current annual expenses of $45K, she withdraws $25K per year from her investment portfolio.

At the end of 2010, Jane, no longer able to care for herself, enters a nursing home, at a cost of $80K/year. Upon entering nursing home care, Jane’s other annual expenses decrease to $5K.  In 2011, Jane’s annual expenses will be $85K, requiring her to withdraw $65K per year from her investment funds.

Assuming no investment growth, Jane’s funds would be depleted in 2015, when Jane is age 90.  However, Jane (or possibly her children) can use a reverse mortgage or an outright sale of her home to provide more funding for her Long Term Care.  In this scenario, Jane will likely never outlive her financial resources.

When considering “self insurance”, remember that the cost of nursing home care is offset by a significant reduction in current expenses.  It is also important to consider the value of a home and other non-liquid, but salable assets in determining if self insurance is right for you.

Long Term Care requirements will affect many baby boomers.  If you are a member of this generation, now is the time to determine what financial strategies meet your LTC requirements.

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The health care bill, enacted in March, includes two new Medicare taxes on the “wealthy.’  While you may not consider yourself wealthy, there is a reasonable chance that you may have the opportunity to pay one or both of these taxes.  Let’s examine these new Medicare taxes to determine if they might be part of your financial future.

The first tax is a 62% increase (from 1.45% to 2.35%) in Medicare taxes for individuals with earned income over $200K and for couples with earned income over $250K.  While a single person earning over $200K per year is highly compensated, couples need only earn more than $125K each to be engulfed by this new tax.  As usual, the minimum earnings amount is not tied to inflation.  If 1970s style inflation appears in the next few years, earnings of over $125K may become much more common.

The second Medicare tax on the “wealthy” is a 3.8% tax on investment income for singles with an Adjusted Gross Income (AGI) exceeding $200,000 and couples with an AGI exceeding $250,000.   Let’s look at a scenario in which a couple whose earnings are less than $250K could end up paying almost $75K for this new tax.

You and your spouse are 60 years old and owners of a small Sub Chapter S Corporation.  Your joint salaries total $175K.  Through diligent saving over the past 35 years and a small inheritance, you have $1 million dollars in investments to help provide for a reasonable standard of living in your retirement years.

In 2013, the economy finally begins to recover and your business booms, throwing off $75K in dividend income.  At the same time, the stock market finally recovers and you have a 15% return on your investments.

Your AGI from salary and company dividends in 2013 is $250K.  Because of this “wealth,” the $150K in investment income from your savings would be taxed at the then current income tax rate plus you would pay an additional $5,700 in Medicare taxes.

After paying these high taxes in 2013, you decide to sell your business and retire in 2014.  The business sells at the end of 2014 for $1 million.  In 2014 your salaries and dividends from the business total $200K and your investments provide an 8.7% return of $100K .

For 2014, your AGI from salary and company dividends in 2013 is $200K, while your total investment gains (including the sale of your company) are $1.1 million.  The new 3.8% Medicare tax on the “wealthy” would cost you an additional $39,900 above your already high 2014 taxes.

In 2015, you decide to downsize your house, built in 1975 at a cost of $40,000, as well as sell your ski condo that you bought in 1980 for $60K.  Living in Boulder, your house sells for $940K and your condo sells for $460K.  While you have $0 earned income, your investment portfolio increases by approximately 10%, providing $200K in investment income.  Even with the $500K capital gains exclusion for the sale of your home, your total taxable investment income in 2015 is $1 million.  Since $750K of the investment income is taxed at the additional 3.8% rate, the new Medicare tax adds $28,500 to your 2015 tax bill.

The small business owners in the above scenario would hardly be considered “wealthy.”  However, in three years, this couple could pay $74,100 in additional Medicare taxes, thanks to health care reform.

There are several ways that this couple could reduce their taxes, but they did not even know about these new Medicare taxes.  As our government needs more and more tax revenue to sustain its profligate spending, tax planning becomes even more critical.

The good news is that these new taxes do not become effective until 2013.  If you are planning on selling your business or home, tax planning now could save you thousands of dollars in taxes later.  Now, more than ever, it is important to do advanced tax planning with a financial professional who fully understands the tax system.  As our example shows, not understanding the new tax laws can be very expensive.

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Many companies are now offering the choice of a “traditional” health care plan or a high deductible health plan (HDHP). Often, the employees are only told that the HDHP costs less (usually by 20% – 30%) and has a higher deductible. The deductible for a family “traditional” plan is often at least $500 per individual and $1,000 for the family. For a HDHP the family deductible is often as much as $3,000.

If your traditional plan costs $200 per month and the HDHP costs $160 per month (20% less) you might be believe that the $40 per month ($480 per year) savings is not worth the risk of possibly paying $2,000 more in deductible expenses. This could be true, if you do not take advantage of the tax free Health Savings Account (HSA) that can be matched with the HDHP.

However, if you are in at least the 25% federal income tax bracket and deposit the family policy maximum of $5,650 into your HSA, the cost of an HDHP will always be less than a the cost of using a traditional plan. If you are in the 25% federal tax bracket, the $5,650 HSA deposit will provide a federal income tax savings of ($5,650 *25%) = $1,412.50.

Next, using your HSA for medical expenses lets you pay for them with tax-free dollars. The $3,000 deductible can be paid with these tax-free funds. This reduces the $3,000 cost by your 25% tax bracket to a cost of $2,250 on an after tax basis.

Let’s add up the after tax costs of each plan. The traditional plan costs $480 more and saves you ($2,250 – $1,000) = $1,250 on after tax deductible costs, for a net “savings” of ($1,250 – $480) = $800

However, the HSA deposit of $5,650 has an income tax saving of $1,412.50. When the income tax savings is included, the HDHP plan costs ($1,412.50 – $800) = $612.50 less than the “traditional plan, even when your health care costs “max” out the $3,000 deductible.

If you only use $1,000 in medical expenses for the year, the savings with the HDHP is $2,142.50. This represents the sum of the insurance savings ($480), the HSA tax savings ($1412.50) and the savings from paying the deductible with funds that are never taxed ($250).

If you are in a higher tax bracket and/or if you pay state income taxes, your savings with an HDHP are even greater. Plus, the funds remaining in the HSA continue to grow tax free and can be used for future medical expenses tax free.

The bottom line is that, if you are in at least the 25% federal income tax bracket and your company offers an HDHP, you will always come out ahead with the HDHP, as long as you contribute the maximum amount allowed to your HSA.

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As discussed in the Financial Abundance Guide, if your marginal federal income tax rate is 25 percent or higher, on an after tax basis, you will save money with a High Deductible Health Plan (HDHP), when you fully fund your Health Savings Account (HSA).  In 2007, if you are single and your Adjusted Gross Income (AGI) is over $31,850 or filing jointly with an AGI over $63,700, an HDHP/HSA combination will save you money, as long as you fully fund your HSA.

For many people, the ability to fully fund their HSA may be a challenge. “Fully funding” requires that a single person deposit $2,850 or that a family deposit $5,650 into an HSA.  To help solve this problem, the Tax Relief and Health Care Act of 2006 allows you to do a one-time funding of your HSA by rolling over IRA funds into your HSA.

This rollover is similar to doing an IRA to Roth IRA conversion. However, with an HSA rollover, you are not required to pay taxes on the funds transferred to your HSA (as long as you maintain your HDHP for at least 12 months).  Like a Roth IRA, all HSA funds grow on a tax free basis and can be withdrawn tax-free, as long as the funds are used to pay for health care related expenses.

Another one time funding source for your HSA is a rollover from an employer-sponsored flexible spending account (FSA) or health reimbursement account (HRA).  Your rollover is limited to the account balance on the date of transfer or on September 21, 2006, whichever is less.  The rollover must also be made before January 1, 2012.  If your yearly FSA contributions will not be consumed, this approach may keep you from losing the remaining FSA funds.

If you have a High Deducible Health Plan (HDHP), fully fund your Health Savings Account (HSA).  By doing this, your total after-tax health care costs are virtually guaranteed to be lower than they would be with a comparable “low deductible” health care plan.

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