Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)
Part VII. Other Important Things to Know
Chapter 34. Tax Implications of Health Care Reform
Everything You Need to Know
Many people are wondering how new taxes created in the Affordable Care Act (a.k.a. ObamaCare) will affect them. In one way or another, this new bill will touch everyone. For some, the impact will be significant. Although some pieces of this chapter are scattered throughout this book in areas that the new law affects (while other parts are found only in this chapter), it is important to put the whole picture together in one chapter because of the broad impact the ACA and its provisions will have on so many people.
Before getting into the details, you should understand that the most significant tax changes that come from this new law began to take effect in 2013 and later. I have organized this chapter into three main sections, based on who is affected by various parts of the law. The three sections focus on:
· The effect on individuals
· The effect on businesses
· The effect on health insurance plans
The Effect on Individuals
The key revenue raiser in the bill is the Medicare surtax (surtax is a tax added to another tax). There are actually two surtaxes. The first is an additional 0.9% tax on all wages and self-employment income (“earned income”) over a certain threshold. The second is a 3.8% tax on “unearned income.”
Example Archie is a single, self-employed investment advisor. He spends a lot of his free time working on his personal investment portfolio. His total income for the year is $300,000, of which $250,000 came from his business and $50,000 from his investments. Because of the new law, Archie will pay:
A $450 surtax on his self-employment earnings, because they exceeded the threshold.
A $1,900 surtax on his “unearned” investment income.
The 0.9% surtax of earned income will be assessed on all earned income above $200,000 for single individuals, and above $250,000 for married couples who file jointly (note the hefty marriage penalty). It is important to understand two key elements of this surtax. First, the thresholds are based on earnings, not on Adjusted Gross Income (AGI) or taxable income. The fact that it is based on earnings, rather than on AGI or taxable income, can result in a significantly higher total tax. Second, for those who have self-employment income, this surtax is not deductible as part of the usual deduction of one half of the self-employment tax, which will result in higher income taxes as well.
Note The $200,000 and $250,000 thresholds are not indexed for inflation. Each year, this new tax will affect significantly more people, simply because of inflation over of time.
The 3.8% surtax of unearned income can be even more significant than the tax on earned income. One reason is that this tax on unearned income is a very significant shift in the tax rules because it applies “employment” taxes to income that doesn’t come from employment. Before the health care reform bill was enacted, Medicare and Social Security taxes (of which these two new surtaxes are a part) applied only to earned income. This change may signal a significant shift in the thinking of lawmakers: they are showing a willingness to apply employment taxes to income that does not come from employment, in order to gather more revenue.
Note This new surtax will apply to unearned income such as interest, dividends, capital gains, rental income, royalties, and nonqualified annuities. However, it will not apply to income from retirement plan distributions (IRAs, 401(k)s, and so on) or to tax-exempt interest.
This tax on unearned income will be levied on taxpayers who have a Modified AGI (MAGI) greater than $200,000 for single individuals, or $250,000 for married individuals. The 3.8% tax is applied to the smaller of their investment income, or the amount by which their AGI exceeds the threshold.
Example Doug and Maxine have an AGI of $280,000 and an investment income of $35,000. The 3.8% surtax will be applied to $30,000 of their income ($280,000 AGI − $250,000 threshold = $30,000, which is smaller than the $35,000 of investment income).
Scott has an AGI of $230,000 and an investment income of $10,000. The surtax will apply to the $10,000 of investment income because it is a smaller number than the amount by which his total AGI exceeds the threshold ($30,000).
This new 3.8% tax will have an especially heavy impact on capital gains income, and even more so on dividend income. With the maximum capital gains tax at 20% and this 3.8% surtax on top of these other tax increases, the maximum taxes on capital gains is be 23.8%—a 60% increase over the previous 15% maximum rates applied to these income sources.
As you can see, if your AGI is above $200,000 or $250,000, this new tax will noticeably affect your marginal income. Keep these changes in mind during your long-term tax planning, giving special attention to the portions of income you’ll expect to get from dividends, self-employment income, and tax-exempt interest.
Reduction in Medical Expense Deductions
Beginning in 2013, allowable itemized deductions for medical expenses will be reduced for those under 65 years old—effectively increasing taxes for those who deduct medical expenses. Previously, if you itemized deductions on Schedule A, you were allowed to deduct all medical expenses in excess of 7.5% of your AGI, as long as you were not subject to the Alternative Minimum Tax (AMT). Beginning in 2013, only medical expenses that exceed 10% of AGI will be deductible.
Example Mary and Jon have an AGI of $80,000. Their total medical expenses for the year add up to $7,800. Under previous law, they could take 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 could deduct no medical expenses because their new floor would be $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 would end up paying an additional $540 in taxes (0.30 × $1,800 that they could no longer deduct = $540).
Penalty Tax for the Uninsured
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 they 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.
Increased Penalty on Health Savings Account (HSA) and Flexible Spending Account (FSA) Withdrawals
If you have an HSA or an FSA, you’ll want to understand two important changes the new bill makes in those accounts. First, as of January 1, 2011, the cost of over-the-counter medicines and drugs are not allowable expenses for HSAs and FSAs, unless you have a prescription. For example, if your doctor writes a prescription for fish oil, though that prescription is not required to purchase the supplement, it makes it okay to purchase the fish oil with your HSA or FSA funds without penalty.
Tip Save a copy of your prescription with your tax records in case of an audit. And of course, keep in mind that your doctor could write a prescription for many things that wouldn’t qualify as a medical expense, regardless of the prescription (such as a prescription to buy a big-screen TV to help you alleviate stress).
The health care reform bill does not require a prescription for deductible medical expenses such as medical devices, glasses, contact lenses, and so on. The rules regarding those items remain the same as they have been in previous years.
The second major change is that if you spend funds from your HSA on non-allowable expenses, you will pay a 20% penalty (in addition to income taxes)—twice as much as the former penalty. These changes began as of January 1, 2011.
Refundable Credit for Low-Income Households to Purchase Insurance
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 $45,680 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.
The Effect on Businesses
Many provisions in this bill will affect employers to varying degrees, based on the size of their company. I here focus only on the effects this bill will have on businesses that employ 50 or fewer people.
By 2014, each state is required to have a health insurance exchange—a place for individuals and businesses to buy insurance. These exchanges will be government regulated and will offer four plans. The major difference between plans will be the co-pay percentage: 60%, 70%, 80%, and 90% for each plan, respectively. Each plan will provide an out-of-pocket maximum equal to the out-of-pocket maximum for HSAs (which in 2014 is $6,350 for individuals and $12,700 for families). Exchanges can also offer a fifth plan, which would be a “catastrophic coverage” plan for young adults. It would offer a bare-bones coverage at a lower cost (perhaps “bare-bones coverage” is a poor choice of words in this context).
Penalties and Limitations
Companies that offer plans with benefits that are too generous will pay a heavy excise tax. Beginning in 2018, a 40% tax will be levied on “excess” benefits offered by the business (unions excluded). A company’s benefits are “excessive” when individual benefits exceed $6,580 and family benefits exceed $17,750 (these are estimates of the 2010 inflation-adjusted numbers that will go into effect). The benefits used in this calculation include the cost of premiums, reimbursements from HRAs and FSAs (even when funded by employee contributions), and employer contributions to HSAs. The dollar amounts of the excess benefit thresholds are indexed for inflation. In 2014 FSAs are capped at $2,500 per year, indexed to change based on inflation each year.
To help cover the cost of insurance coverage, a credit is available to small businesses during the first five years of the new bill. For businesses with 10 or fewer employees and an average employee salary of less than $25,000, the credit is 50% of the cost of premiums (or of the average cost in the state, if lower) for the coverage of employees (but not for the cost of covering the owners). The credit is only available for those companies that purchase their insurance through the government exchanges. It is quickly reduced for companies that have more than 10 employees, as well as for businesses that pay their employees better wages. The credit completely disappears if the average employee wages are higher than $50,000 or if the company employs more than 25 people. The owners and family members of owners are not counted in the employee number or in the average wages.
To qualify for the credit, the employer must pay at least 50% of employee premiums. The credit can be used against the AMT, but it is nonrefundable, so the employer will receive no help in paying for the insurance if he owes no taxes.
Tip This credit is not as beneficial as other credits. This is because the credit takes the place of the health insurance costs the business could have deducted if it had claimed no credit. This increases the company’s taxable income and thus reduces some of the credit’s benefit—at times making it not worth taking the credit at all.
The bill will provide some kind of incentive, through grants, for small businesses to establish workplace wellness plans. The details are still to be determined, but the grants will be available for up to five years to businesses that have 100 or fewer employees who had no such plan before the bill was signed.
The Effect on Health Insurance Plans
In addition to the changes that were mentioned in the “Health Exchanges” section earlier in this chapter, the bill makes a few other significant changes to all health insurance plans. First, all children of employees must be offered coverage up to age 26, even if they are not dependents or students, and even if they are married. The only exception to this rule is if they have coverage through another employer plan—but beginning in 2014 even that won’t matter.
Next, the health insurance plans cannot exclude anyone because of pre-existing conditions. This was the case from the beginning of the law for children younger than age 19, and the rule is also applied to adults beginning in 2014. Adult children (ages 19–26) may face a waiting period for certain pre-existing conditions.
Finally, maximum lifetime benefit limits will be prohibited for nearly all services. This new rule was currently in effect for essential services in previous years, and became effective for other services beginning in 2014.