When it comes to filing taxes, getting the best returns is not about skill – it's about what you know. Unfortunately, many taxpayers miss out on deductions and credits simply because they just aren't aware of them. Several of the most overlooked deductions pertain to health and medical expenses, and insurance premiums. Are you paying more tax than you need to? Read on for some insurance-based deductions you may be missing.
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Disability insurance is probably the most common type of premium that is overlooked as a tax deduction. The deductibility of these premiums, is complicated, however. The IRS permits self-employed taxpayers to deduct "overhead insurance that pays for business overhead expenses you have during long periods of disability caused by your injury or sickness." However, "you cannot deduct premiums for a policy that pays for lost earnings due to sickness and disability. Check with your accountant or other tax advisor to make sure any deductions you take meet IRS requirements.
Also note: If you deduct the premium, any benefits paid from the policy will be considered taxable income. By contrast, policy benefits will not be taxable if you do not deduct the premium, and some taxpayers use this arrangement so that they can receive tax-free benefits if they become disabled. (The Disability Insurance Policy: Now In English will show you how to translate this complicated type of policy.) Benefits are also taxable if your employer paid for your disability insurance, rather than if you bought it yourself with your own after-tax dollars.
Health Savings Accounts
Another insurance–related tax perk that people without access to traditional group health coverage should be aware of is health savings accounts, which combine a tax-advantaged savings element with a high-deductible health insurance policy. All HSA contributions, up to the maximum permitted by law, are tax-deductible, even for those who do not itemize, and earnings accumulate tax-free. All proceeds withdrawn from the account are tax-free, provided they are used to pay for qualified medical expenses. (See Health-y Savings Accounts for further explanation of how HSAs work.)
Timing Medical Expenses
The only medical expenses that are deductible are those that are more than 10% of adjusted gross income (if you or your spouse are 65 or older, the threshold is 7.5% until Dec. 31, 2016). This means that few taxpayers accumulate enough unreimbursed bills in one year to qualify for the deduction. If you have substantial medical bills pending, you can boost your deduction by scheduling other medical procedures or expenses in the same year.
For example, someone with annual adjusted gross income of $40,000 would be able to deduct any medical expenses not covered by health insurance in excess of $4,000. The deduction might include $17,000 of a $20,000 operation not covered by insurance, plus any other unreimbursed expenses incurred in the same year, such as routine medical checkups, dental procedures, chiropractic treatments and even contact lenses and prescription drugs.
However, if you get a check the following year from your insurance company, you will have to declare the amount of the deduction that was reimbursed as income the following year. For example, if you deducted $17,000 for a surgery this year and your insurance company sent you a $10,000 check for the surgery the next year, that amount would have to be declared as income in the year the check arrives. If there's a chance you may get medical expenses covered by your insurance company in the future, do not declare this deduction until you know whether the insurance company will reimburse you. You can always submit an amended return for the year you would have received the deduction if your insurance claim is denied.
Receipt of Unemployment or Workers' Compensation Insurance Benefits
It is important to distinguish unemployment benefits from a state unemployment agency from workers' compensation, which is awarded to workers who cannot perform their duties as a result of injury. Unemployment benefits are always taxable, as they are considered a replacement of regular earned income and should be reported on IRS Form 1040. Workers' compensation is never declarable as income.
Deductions for Businesses and Self-Employed Taxpayers
Self-employed taxpayers and other business entities can deduct business-related insurance premiums of any kind, including health and dental insurance premiums, as well as legal and liability coverage. Vehicle insurance can also be deducted if the taxpayer elected to report actual expenses and is not taking the standard mileage rate.
Life insurance premiums are deductible as a business-related expense, and the death benefit is generally tax-free for individual policy owners. Although death benefits for business-related beneficiaries are often tax-free as well, there are certain situations in which the death benefit for corporate-owned life insurance can be taxable. However, employers offering group-term life coverage to employees can deduct the first $50,000 of premiums that they pay, and amounts up to this limit are not counted as income to the employees. Life insurance premiums can also often be deducted for most types of non-qualified plans, such as deferred compensation or executive bonuses. Usually, the premiums are considered compensation for key executives under the rules of these plans. However, in some cases the deduction cannot be taken until the employee constructively receives the benefit.
Other Qualifying Plans
Nonqualified plans aren't the only type of retirement savings vehicle that can be funded with tax-deductible premiums: 412(i) plans are qualified, defined-benefit plans that can provide substantial deductions for small-business owners looking to catch up on their retirement savings and receive a guaranteed income stream. These plans are funded solely with insurance products such as cash value life insurance or fixed annuity contracts, and the plan owner can often deduct hundreds of thousands of dollars in contributions to these plans each year.
Finally, participants in standard qualified plans, such as 401(k) plans, can purchase a limited amount of either term or permanent coverage subject to specific restrictions. But the coverage must be considered "incidental" according to IRS regulations. In any type of qualified defined-contribution plan, the cost of whole life premiums for each participant must be less than 50% of the employer's contribution amount, plus forfeitures.
For term and universal coverage, the limit is 25%. This is the only instance where individuals can purchase life insurance on a tax-deductible-basis (assuming the plan is a traditional plan and not a Roth plan.) Life insurance death benefits paid out of qualified plans also retain their tax-free status, and this insurance can be used to pay the taxes on the plan proceeds that must be distributed when the participant dies.
The Bottom Line
This article only mentions a few of the more commonly overlooked deductions and tax benefits related to insurance for which business and individual taxpayers are eligible. Other deductions relating to compensation, production, depreciation of buildings and equipment are listed on the IRS website in various downloadable instruction manuals. For more information, visit http://www.irs.gov/ or consult your tax advisor.