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, medical expenses, and insurance premiums.
For the most part, the new Trump tax bill—2017 Tax Cuts and Jobs Act (TCJA)—seems to leave most of the deductions discussed below unchanged with one exception, the medical expenses. Read on for some insurance-based deductions you may be missing.
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 advisors to make sure any deductions you take meet IRS requirements.
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. 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. Here is a link to the most recent version of IRS Publication 535, Business Expenses.
Health Savings Accounts
Another insurance-related tax perk that people without access to traditional group health coverage should be aware of is the health savings account, which combines 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 All proceeds withdrawn from the account are tax-free, provided they are used to pay for qualified medical expenses.
The only medical expenses that are deductible have been those that are more than 10% of adjusted gross income (a break for seniors ended with the 2016 tax year). This means that few taxpayers accumulate enough unreimbursed bills in one year to qualify for the deduction. Under the new tax law, starting with the 2017 tax year (taxes due on April 17, 2018), the threshold drops to 7.5% for the 2017 and 2018 tax years. Beginning with the 2019 tax year, the level returns to 10%.
If you have substantial medical bills pending, you can boost your deduction by scheduling other medical procedures or expenses in the same year – and especially by scheduling as much as possible for the 2018 tax year (taxes due in April 2019). The lower threshold will still be in force for 2018.
Someone with an annual adjusted gross income of $40,000 would be able to deduct any medical expenses not covered by health insurance in excess of $3,000 in the 2018 tax year. Starting in the 2019 tax year, that threshold would rise to $4,000, its previous level. 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 – even contact lenses and prescription drugs.
One caveat: 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 surgery in one 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.
It is important to distinguish unemployment compensation from a state unemployment agency from workers' compensation, which is awarded to workers who cannot perform their duties as a result of an 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 the Self-Employed
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 (if the insured is an employee or a corporate officer of the company, and the company is not a direct or indirect beneficiary of the policy). 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 premiums they pay on the first $50,000 of benefits (per employee), 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.