Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)
Part VI. Personal Expenses, Deductions, and Credits
The vast majority of personal expenses are not allowed as tax deductions. The reason for this is clear: If we were allowed to deduct all of our personal expenses from our income there would be very little left to tax. However, Congress has deemed certain personal expenses important enough (for a variety of reasons) to subsidize and encourage those expenses through deductions and credits in the tax code.
Each of these deductions and credits has varying levels of benefit, based on the way the tax code is written. These variations are also due, in part, to your personal circumstances and the way that they play out on your tax return. Carefully study the chapters in Part VI to learn which of these strategies will bring worthwhile results.
Chapter 26. Medical and Dental Expenses
There’s Never a Good Time for These Expenses, but at Least You Can Deduct Them
I have found that most itemized deductions remain about the same from year to year for most of my clients. Their mortgage interest and property taxes usually don’t fluctuate very much. They donate about the same amount to charities each year. However, one deduction that changes significantly from year to year is medical expenses. Expenses for doctors, dentists, hospitals, health insurance, and other related items can be deducted from your taxable income as an itemized deduction and sometimes can add up to a significant break on your tax bill.
There are two significant types of personal medical deductions that can be taken on an individual’s return (for the business deductions see Chapter 20), as well as one new tax and credit that applies to those who don’t have health insurance. The three topics covered in this chapter are:
· Itemized medical deductions
· Health Savings Accounts
· Health Care Coverage Tax and Credit
Itemized Medical Deductions
Medical expenses are one of the best-known itemized deductions. The only solace that people can find in paying high fees to their doctors and dentists is in the hope that they can claim it as a write-off come tax time. For some people, medical expenses end up being the greatest reducer of their tax bill. However, for many this is not the case because the laws governing this deduction have several things in place that can limit or even eliminate your ability to claim those expenses.
To claim medical expenses as an itemized deduction you must first be able to cross a few tax-law hurdles. First, medical expenses must “qualify” as deductible medical expenses. This hurdle is not very high, in my opinion, as the list of qualified expenses is very long and fairly generous. However, there are many things that you could conceivably argue are medical expenses that will not be accepted. For example, a perennial favorite that shows up in the tax court is a person claiming that a tropical vacation was a necessary medical expense. It well may be that a vacation is necessary and good for your health . . . but it’s definitely not a deductible expense.
The second, more difficult hurdle is that only those qualified expenses that exceed a certain percentage of your Adjusted Gross Income (AGI) can be taken as a deduction. In 2014 that hurdle is 7.5% of AGI if you are over 65 years old, and 10% for everyone else. If you are subject to the Alternative Minimum Tax (AMT) it’s even worse—you can deduct only those expenses in excess of 10% of your AGI, regardless of your age.
Example Lucy is 68 years old, her AGI is $60,000, and her total medical expenses for the year were $6,000. She is allowed to deduct $1,500 in medical expenses as an itemized deduction, which are the amount of expenses that were in excess of the 7.5% floor, or $4,500 ($60,000 × 7.5% = $4,500). If she were subject to the AMT, however, she would not be able to deduct any of her medical expenses for the year because they do not add up to more than 10% of her AGI.
In 2013 a new rule came into effect that increased the AGI to 10% for all taxpayers under 65, regardless of whether they are subject to the AMT. This tax increase is a result of the Affordable Care Act (a.k.a. ObamaCare). This is one of the many adjustments that were made to the tax laws to pay for this new program. This higher floor will affect a significant number of people when they file their returns—eliminating the deduction for a large number of people, and limiting it for many others.
Example Mary and Jon have an AGI of $80,000. Their total medical expenses for the year add up to $7,800. Under 2012 law they could have taken an itemized deduction of $1,800, the amount of expenses that exceed the 7.5% floor, which in their case is $6,000 ($80,000 × 0.075 = $6,000). Beginning in 2013, under the same circumstances, Mary and Jon cannot deduct any medical expenses because their new floor is $8,000 (10% of AGI), which is greater than their $7,800 of expenses. If their combined federal and state marginal tax brackets equaled 35%, they will end up paying an additional $540 in taxes (0.30 × $1,800 that they could no longer deduct = $540).
The third hurdle that you must cross to claim medical expenses as an itemized deduction is that all of your itemized deductions, added together, must be greater than the standard deduction in order to receive any benefit. Otherwise, it would be more beneficial to take the standard deduction and the medical and other deductions become inconsequential. These three hurdles combine to make it so that a surprisingly small portion of the average person’s total medical expenses are actually deductible.
Tip If you are in a position to control when you pay for your medical expenses, you can plan those expenses in a way that will help you reap the greatest benefit. Aim to delay procedures until late enough in the year that you can pay for them in the following year. Then, in the following year be sure to pay for all new expenses before the year’s end. In that way you can increase the amount of medical expenses that are deductible in one year (above 7.5 or 10%) and get more deductions out of those expenses than you otherwise would have by spreading them out over the two years.
Caution While the timing of payments is a legitimate strategy for maximizing your medical expense deduction, it is not possible to utilize this strategy by pre-paying your medical bills. Pre-payments for services not yet rendered are not deductible until the service is received.
One key to making the most of this strategy is being aware of all of the expenses that qualify for the deduction. There are many expenses that are not covered by health insurance companies (such as chiropractic care and acupuncture) but are actually considered deductible expenses in the tax code. In addition to the obvious out-of-pocket medical expenses, tracking and claiming some frequently overlooked medical expenses often can get you over the 7.5% or 10% hurdle and allow you to take some of your medical expenses as deductions. Here are some examples:
· The mileage that you put on your car for medical purposes is a deductible expense. All travel necessary to visit a doctor, hospital, or pharmacy can be deducted at a standard rate of $0.235 per mile in 2014, plus parking and tolls. If you are going to claim a mileage deduction, keep accurate records of starting and ending odometer readings, the reason for the travel, and the dates. Also get a third-party record of your vehicle’s mileage at the beginning of each year (such as a receipt from an oil change). These things will help you keep the deductions you claimed if you are faced with an audit.
· Meals eaten during medical trips away from home can be claimed as a medical expense, as well as $50 per night, per person for lodging if you are an outpatient of a hospital or clinic and there is no significant element of pleasure involved in the travel (i.e., you are there for treatment and not sightseeing or other such things during that time). Notice that it is a per-person amount, so a parent taking a child to a clinic, for example, would allow for $100 per night in deductions (and, no, a family of six does not mean a $300 deduction—only one additional person and only if necessary).
· Health and dental insurance premiums are deductible. Many do not think of insurance as a medical expense, but it is deductible as long as you haven’t used the self-employed health insurance deduction. The cost of Medicare Part A and Part D is considered a deductible health insurance expense, so be sure to include it in the calculation if you participate in those programs.
· If you have long-term care insurance, a portion of the premiums may be deductible.
· The expense of home improvements or additions that are primarily for medical care are deductible to the extent that they cost more than the value they add to the property. For example, if a wheelchair ramp costs $3,000 to install and increases the value of the home by $1,000, then $2,000 is deductible as a medical expense. If the improvement adds no value to the home, the entire expense is deductible.
A more comprehensive list of qualified medical expenses is included at the end of this chapter, as is a list of those items that are not deductible.
Tip The self-employed health insurance deduction often produces a better tax result than counting your premiums toward the itemized deduction, even if you are unable to cross the 7.5% (or 10%) hurdle without the premiums. If you are a business owner, look first to that deduction, if you qualify. See Chapter 20 for more details.
Your medical expenses include those paid for you, your spouse, your dependents, and anyone you could have claimed as a dependent (e.g., “dependents” whose income level was too high for you to claim them). You cannot claim a deduction for expenses you paid for anyone else.
You must keep good records and have receipts for all of your medical expenses. Expenses that are reimbursed by a health insurance plan or an employer are not deductible. Expenses paid for with funds from a Health Savings Account (HSA) are also not deductible.
Health Savings Accounts (HSAs)
Health Savings Accounts (HSAs) are special savings accounts, much like IRAs, are set aside specifically for medical expenses. To encourage people to save for medical expenses (and reduce the overall burden on the government), lawmakers allow individuals to claim a tax deduction from their income when they contribute funds to an HSA. Every dollar contributed to the HSA directly reduces your AGI and taxable income by one dollar as well.
Money in an HSA can be withdrawn tax-free at any time, as long as it is used for qualified medical expenses. This tax treatment is significant— you receive a deduction for the contribution and you are not taxed when the money is withdrawn, meaning that the money contributed to an HSA is never taxed. There is no other arrangement treated so favorably in the tax code. HSAs are the most beneficial thing that Congress has created for the American taxpayer in decades.
As discussed in the previous section, medical expenses can be deducted from your taxable income only if you itemize deductions and if those expenses exceed the 7.5% or 10% of AGI floor. Otherwise you receive no tax benefit from those medical expenses (and even if you do, a significant portion of those expenses remain un-deductible).
Example James is a 66-year-old professional fisherman in Louisiana. This year he had an AGI of $80,000 and $6,500 in medical expenses. He can deduct only $500 of those expenses (7.5% × $80,000 AGI = $6,000 nondeductible expense → $6,500 expenses − $6,000 nondeductible = $500 deductible). If James were subject to the AMT, he would get no deduction because his expenses would not exceed the nondeductible amount (10% × $80,000 = $8,000 nondeductible).
With an HSA you are able to circumvent these rules. Even if you only contributed to an HSA the amount of money that you owe for medical expenses and you turn right around and pay the money out of the account, you would be better off on your taxes because you would circumvent the itemization requirement for deductible expenses and avoid the 7.5% or 10% of AGI floor that limits those deductions. In this way you can deduct every dollar that you spend on medical costs, not just those that exceed the AGI floor.
An additional benefit to HSA contributions is that the AMT has no effect on your ability to claim the deduction, as it does when you’re itemizing. In fact, the AMT is reduced when you claim the HSA deduction because it directly reduces your AGI and your taxable income.
HSAs offer a tax planning option that is close to a rare “double-dipping” opportunity in the tax code. To achieve the maximum benefit of an HSA, follow these steps:
1. Contribute the full amount allowable to your HSA in order to get the maximum deduction.
2. Withdraw no money from the HSA for medical expenses you incur—just leave all of the funds in the HSA.
3. Allow the contributions to grow tax-free for the future.
4. Pay all of your current medical expenses out of pocket. Included in those expenses is the cost of your health insurance premiums (which cannot be paid from the HSA).
By following these steps you will not only get a tax deduction for the HSA contribution, but you will also get an additional deduction for expenses over 7.5% (or 10%) of AGI (including premiums) if you itemize. On top of that you will receive tax-free growth on the money invested in your HSA. Isn’t that beautiful?
If your budget is really tight and you can’t afford to contribute the maximum amount to an HSA, at a minimum you should put money into the account as you pay your medical bills. If a doctor bills you for $150, send the $150 to your HSA first and then pay the doctor from the account. Doing so will usually bring a greater tax benefit than paying the doctor from funds outside the HSA. In this way you ensure that each dollar you pay in medical expenses becomes a deduction. If you pay with funds outside the HSA, your medical expenses will be limited by the itemization thresholds.
Once you make a contribution you can withdraw the funds at any time. While the money is in the HSA, it can be invested and grow tax-free. When you need the money, you can withdraw it tax-free, as long as you use it for medical expenses. If you don’t use the money in the savings account for medical expenses, you can use it for any expenses once you reach retirement age (59½). If you use the money for non-medical expenses after that point, the amount withdrawn will be subject to income taxes, in the same way all non-Roth retirement accounts are taxed, but would not be subject to any penalties.
Tip Contributions to an IRA or 401(k) do not limit your ability to contribute to an HSA. If you have made the maximum contribution to an IRA, an HSA could be a great way to significantly increase the contribution you can make to an IRA-like account. In addition, HSA contributions have no high-income cap. High-income earners who might not be allowed to make contributions to an IRA can contribute to HSAs. See Chapter 15 for more details.
Caution Don’t use HSA funds for unqualified medical expenses before you are 59½. If you do, you will pay taxes on the amounts used, as well as a 20% penalty.
Contributions to an HSA are limited to a maximum amount each year (determined by the IRS). If you are older than the age of 55, you can contribute an additional $1,000 over the annual limits as a “catch-up” contribution. Contributions for a given year can be made up to April 15 of the following year. The maximum contributions to an HSA that are allowed each year increase annually, based on inflation. Table 26-1 show where the annual contribution limits are currently set.
Table 26-1. Maximum Allowable HSA Contributions in 2013
Younger than 50 Years Old
Age 50 or Older
Caution Contribute no more than the maximum allowable for an HSA—you’ll pay fairly steep penalties if you do.
To take advantage of the opportunities that HSA accounts provide, you must first ensure that you have a qualifying high-deductible health insurance plan. The best way to find out whether your plan qualifies is to contact your insurance company or your Human Resources Department if it is through your employer. Once you have the right plan, you must set up an HSA with a provider (the insurance plan and the savings account are completely separate from each other). Many large banks offer HSAs. They usually give you a special debit card for the account, which makes it very easy to access the funds when you need to pay a bill. Once you have the right plan and the account, contribute as much as you can up to the maximum allowed for the year.
Note If you need to switch insurance plans to qualify for an HSA, there is a very good chance that the money you save in premiums will add up to a large portion of the maximum HSA contribution. Contribute at least the amount you save in premiums each month.
With the money that you are able to save in premiums (and deposit in the HSA) you will probably be able to cover and expenses that you have to pay because of the higher deductible. If you don’t have many expenses, then you have truly saved money that you would have otherwise spent on premiums.
There are just a few other items to be aware of before opening up your HSA account. First, you could be ineligible for an HSA because of an employer-sponsored health plan, unless it is an HSA plan. Be sure to check with your human resource department if you receive your insurance through an employer. Second, you can purchase over-the-counter medications with HSA funds only if they are prescribed by a doctor. And finally, as with all great tax strategies, keep good records of the medical expenses you pay for using funds from your HSA.
Health Care Coverage Tax and Credit
All insurance programs need a mix of healthy individuals along with the sick ones in order to spread out the cost of coverage over more people. For this reason, the creators of this bill needed a way to encourage those who don’t need insurance to buy it anyway—or at least to pay into the system if they refuse.
Beginning in 2014, if you’re not insured at the minimum level of coverage dictated by the government, you will pay a penalty tax. In 2014 the penalty equals the greater of:
· 1% of all income in excess of the filing thresholds (which in 2014 are $10,150 for single individuals and $20,300 for married couples under 65). Or,
· A minimum penalty of $95 per adult and $47.50 per child under age 18, with a family maximum of $285.
· The maximum penalty under the 1% method is the national average premium of the bronze level health plan, which is $2,448 per individual and $12,240 per family.
The penalty increases dramatically over the following two years (2015 and 2016). In 2015 the penalty is 2% of income, with a minimum penalty of $325 per adult. In 2016 the penalty increases to $2,085, and it is indexed to increase with inflation each year thereafter.
Insurers will send 1099 forms to the IRS to prove coverage of those with individually purchased plans. If your insurance is provided by an employer, the value of your insurance will be reported on your W-2. Using these two methods the IRS can verify that each person is covered by a qualifying health insurance plan so that it can in turn charge the penalty to those who are not.
Tip If the penalty goes unpaid, the IRS cannot charge additional penalties or interest on the original penalty. Nor can the IRS file a levy or lien to collect the penalty. Their only means of collection is to withhold the amounts owed from future refunds. This nuance will make for some interesting tax planning for a few people out there, I am sure.
The bill includes a refundable credit to low-income households to help them fund the purchase of insurance through the government “health exchanges.” The value of the credit will be based on a percentage of the household’s income. The credit will be sent directly from the Treasury to the Exchange, so it will not come in the form of money to the individual.
To qualify for the credit your income will need to be between 100% and 400% of the federal poverty level. In 2012 a family of four would qualify for the credit if their income fell between $23,850 and $95,400 (between $11,670 and $46,680 for a single individual). Families with incomes below these levels do not qualify for the credit because they would qualify for other government assistance for their health care needs.
Qualified Medical Expenses
Although not exhaustive, the following list gives you an idea of allowable medical expenses. Some of the items on this list may surprise you:
· Abortion (where legal)
· Adoption (medical costs for the child but not the birth mother)
· Air conditioner (for allergy relief and cystic fibrosis)
· Alcoholism treatment
· Animals (seeing-eye dog, hearing dog or animal, and other medical-assistance animals)
· Attendant for blind or deaf student
· Braille literature (only the excess over the regular cost)
· Car (equipment to accommodate wheelchair or special controls)
· Childbirth preparation classes for the mother
· Christian Science treatments
· Computer data storage of medical records
· Contact lenses
· Contraceptive prescriptions
· Cosmetic surgery for deformities (not for unnecessary reasons)
· Deafness aids (hearing aid, animal, lip reading, special telephones and televisions)
· Dental expenses
· Diapers needed for a severe neurological disease
· Domestic aid given by a nurse
· Drug-addiction recovery
· Dyslexia training
· Eye exams
· Fertility treatments
· Health club (only if prescribed by a doctor for a medical condition)
· Hospital care
· Native American medicine man
· Insurance (accident, health, medical, dental, contact replacement, Medicare Part A & D)
· Lab fees
· Laser eye surgery
· Lead-paint removal
· Lifetime medical care (prepaid)
· Limbs (artificial)
· Lodging (limited to $50 per night)
· Long-term care expenses
· Mattress (prescribed for arthritis)
· Nursing home
· Nursing services
· Operations (only legal ones)
· Orthopedic shoes
· Oxygen equipment
· Special plumbing for the handicapped
· Prescription drugs
· Psychiatric care
· Reconstructive surgery
· Sexual dysfunction treatment
· Smoking cessation
· Sterilization operation
· Swimming pool for polio or arthritis treatment
· Taxicab to medical care
· Transplants (donor’s cost)
· Transportation for medical care
· Weight-loss program for a specific disease
· Wig (when related to a disease)
Here is a list of some of the expenses that are not allowed as deductions. I enjoy looking at this list to see the creative things that people have tried to claim as a medical expense. This list is not exhaustive, but should give you a good idea of what not to claim:
· Adoption (medical expenses for natural mother)
· Child care while parent sees doctor
· Cosmetic surgery (when unnecessary)
· Dancing lessons
· Diaper service
· Drugs (when illegal under federal law, even if prescribed)
· Dust elimination
· Ear piercing
· Funeral expenses
· Hair transplants
· Health club dues, not prescribed for a specific condition
· Hygienic supplies
· Life insurance
· Marriage counseling
· Scientology audits and processing
· Self-help medical remedies
· Spiritual guidance
· Teeth whitening
· Weight-loss programs for appearance, even if prescribed