When it comes to filing taxes, getting the lowest tax liability is not all about skill—it's about what you know. Unfortunately, many taxpayers miss out on deductions and credits simply because they aren't aware of them. Several of the most overlooked deductions pertain to health and medical expenses, as well as to insurance premiums.
The 2017 Tax Cuts and Jobs Act (TCJA) eliminated many deductions, but it left most of the ones discussed below unchanged.
- Many missed deductions are related to insurance premiums, medical expenses, and other health-related costs.
- Disability insurance is an important but complicated tax deduction.
- Health Savings Account (HSA) contributions are tax-free up to a predetermined cap.
- Life insurance and business-related insurance premiums also may qualify.
1. Disability Insurance
Disability insurance is probably the most common type of premium that is overlooked as a tax deduction. This type of insurance can provide supplemental income if you're disabled and can't work. The deductibility of these premiums, however, is complicated and limited.
The Internal Revenue Service (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." But "you can't deduct premiums for a policy that pays for lost earnings due to sickness or disability." Essentially, the only disability insurance that is eligible for deduction is the kind that covers business overhead expenses while you're out on leave. This type of insurance would cover items such as rent and utilities that are unavoidable for the duration of a disability leave.
If you deduct the premium, any proceeds paid from the policy will be considered taxable income. By contrast, policy benefits will not be taxable if you pay for the premium yourself and do not deduct the premium, and some taxpayers use this arrangement so that they can receive tax-free benefits to cover business overhead expenses if they become disabled. Proceeds are also taxable if your employer paid for your disability insurance, rather than if you bought it yourself with your own after-tax dollars.
There are several rules to follow if you deduct health insurance expenses, based on your employment status, whether you itemize deductions, and whether you’ve paid your premiums using pre- or post-tax dollars.
2. Health Savings Accounts
Another insurance-related tax perk that people without access to traditional group health coverage should be aware of is a health savings account (HSA), 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 on Schedule C. For tax year 2020, you can contribute up to $3,550 ($3,600 in 2021) if you have a single coverage plan or $7,100 ($7,200 in 2021) if you have a family plan—with an additional $1,000 contribution allowed for taxpayers over the age of 55.
Employers can also make contributions to an HSA on behalf of employees, similar to a 401(k). However, the sum total of employer and employee contributions can't exceed the annual contribution limit for each coverage type. Learn more about the pros and cons of HSAs and whether this option is right for you, here.
Health Savings Accounts can yield a triple tax benefit in the form of tax-deductible contributions, tax-deferred growth and tax-free withdrawals when funds are used to pay for qualified medical expenses.
3. Medical Expenses
Medical expenses are deductible but only in the amount that they surpass a certain percentage of the taxpayer's adjusted gross income (AGI). That percentage keeps changing due to various legislation (most recently ranging from 7.5% to 10%), but it always stays high enough to keep most people from qualifying. The percentage is 7.5% of your AGI for the 2020 tax year.
If you have substantial medical bills pending, you can boost your deduction by scheduling other medical procedures or expenses in the same year. One caveat is that if you get a reimbursement 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. You can always submit an amended return for the year you would have received the deduction if your insurance claim is denied.
4. Unemployment/Workers' Compensation
It is important to distinguish unemployment compensation paid through 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 for regular earned income. You will receive a Form 1099-G listing the total unemployment compensation you received throughout the year, and this amount should be reported on IRS Form 1040. Workers' compensation benefits you receive should not be declared as income. This also includes survivor's benefits.
5. Deductions for the Self-Employed
Self-employed taxpayers and other business entities can deduct business-related insurance premiums, including health and dental insurance premiums, as well as long-term care premiums. Vehicle insurance can also be deducted if the taxpayer elected to report actual expenses and is not taking the standard mileage rate. To learn about more deductions available to self-employed individuals, read this article.
Be sure to keep documentation of all premiums paid toward eligible insurance expenses, as well as any other deductible expenses you plan to claim, such as computer equipment or a home office.
6. Other Qualifying Plans
Qualified plans aren't the only type of retirement savings vehicle that can be funded with tax-deductible premiums: 412(i) plans are also tax-deferred. This defined-benefit plan can provide substantial deductions for small-business owners looking to catch up on their retirement savings and receive a guaranteed income stream in the future. A 412(i) plan is funded solely with insurance products such as cash value life insurance or fixed annuity contracts, and the plan owner can deduct up to hundreds of thousands of dollars in contributions to this plan every year.
Participants in standard qualified plans, such as 401(k) plans through an employer, can purchase a limited amount of either term or permanent life insurance coverage, subject to specific restrictions. But the coverage must be considered "incidental" according to IRS regulations. According to the IRS, an insurance policy is considered to be "incidental" if "less than 50 percent of the employer contribution credited to each participant’s account is used to purchase ordinary life insurance policies on the participant’s life."
Life insurance death benefits paid out of qualified plans enjoy 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.
7. Are Life Insurance Premiums Tax Deductible?
Life insurance can help you provide a measure of family security for your loved ones if something should happen to you. You may be wondering whether life insurance premiums are deductible on your personal tax return and the answer is generally no. But 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 and their beneficiaries.
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.
The Bottom Line
These are only a few of the commonly overlooked deductions and tax benefits related to insurance for which business and individual taxpayers are eligible. Other deductions relating to compensation, production, and depreciation of buildings and equipment are listed on the IRS website. Talking to your accountant or another tax professional can help you determine which tax deductions related to insurance you're eligible to claim to help minimize what you owe.