Self-Employed People Might Want to Avoid Getting Subsidies for Their Health Insurance

March 28, 2014

We’re just about at another deadline for people to sign up for qualifying health insurance, or face a penalty for being uninsured when they file their tax return for 2014. So hopefully this doesn’t come too late for you, but I’ve been thinking about a particular aspect of the law that applies to self-employed people.

Self-employed people are able to deduct the cost they pay for health insurance and reduce their Adjusted Gross Income (AGI). To determine if people qualify for subsidized health insurance (aka “premium assistance”) based on their income level, the government uses Modified Adjusted Gross Income (MAGI), which in this case is defined as Adjusted Gross Income, plus excluded foreign income, non-taxable Social Security benefits, and tax exempt interest. So we run into circular logic here, because the amount you pay for health insurance depends on your MAGI, but your MAGI in turn depends on how much you pay for health insurance.

I’ve seen a few discussions of this problem, some of which propose rather complicated iterative mathematical solutions, but I think the solution is fairly simple and presents a clear planning opportunity for self-employed individuals who potentially qualify for health insurance subsidies under the Affordable Care Act. And depending on your household size, you could potentially qualify with a MAGI of well over $100,000. For example, a family of 5 qualifies for subsidies with a MAGI of $110,280 or less.

Based on a plain reading of IRC 162(l) (“allowed as a deduction (…) the amount paid during the taxable year for insurance (…)”), it appears that if you choose to pay full-price for your health insurance then you can deduct the full cost you pay during the taxable year, thus reducing your MAGI as low as possible. When you file your tax return at the end of the year, you’ll fill out whatever form the IRS provides to determine what amount of subsidy you’re actually eligible for based on 2014 MAGI, and claim the subsidy as a tax credit on your return. Using this method, you could potentially qualify for a significantly larger amount of premium assistance than if you applied for the subsidized premium amount up front and paid less for insurance during the year (thus increasing your MAGI).

Of course, it’s not a totally free lunch. Under the principle that if you deduct something that’s later refunded/reimbursed, then you simply claim the subsidy as income on the following year’s taxes. This is actually quite common when it comes to medical expenses. We sometimes see in the tax world that somebody will have to pay for major medical expenses out of pocket, and then they take a tax deduction for those expenses. Later, when they finally get the insurance company to reimburse them for their costs, they have to include the reimbursement as taxable income. So getting reimbursed for part of your health care costs after year end really isn’t even a new concept.

Here’s a simple example of how this might benefit you: In 2014, imagine I’m married no kids and make $65k/yr. If I don’t take the advance subsidy, we’ll say my insurance costs are $5k/year, making my MAGI $60k/yr. So I claim a credit for (let’s say) $3k. Since that’s a refund of premiums I deducted, I report the $3k as income in 2015.

If I do take the subsidy, we’ll say I pay only $2k/year for insurance. (The cut-off for the subsidy for 2 people is ~$62k/yr.) By paying only $2k/yr, my MAGI is $63k/yr and I no longer qualify for the subsidy…so now I have to PAY BACK the $3k/yr advance subsidy that I don’t actually qualify for.

In the first scenario, I paid $5000, got $3000 refunded, but have to pay tax on that $3000. At that income level for a married filing joint taxpayer, I’m probably paying 15% on that $3k, so overall I’m out about $2500.

In the second scenario, I pay $2000 during the year and another $3000 at year-end, so I’m out $5000. Overall, I’m $2500 better off paying full price up front and then taking the subsidy at year-end when I file my taxes!

Moral of the story: If you’re self-employed and potentially eligible for a subsidy, do not take the subsidy during the year.

Disclaimer: The above advice is based on a plain reading of the Internal Revenue Code and the application of logic and common tax principles. This does not mean the IRS will necessarily use logic, common tax principles, or a plain reading of the Internal Revenue Code when they create the forms and instructions to handle the premium subsidies/tax credit. (Though to be fair, as popular as it is to knock the IRS, I find that the vast majority of the time the IRS’ interpretation of the tax code is consistent with how most intelligent tax practitioners — not to mention most of the legal community — interpret it.) I’ve heard other theories of how the IRS may interpret this law, but to be honest none of the other interpretations I’ve read seem consistent. Regardless, I’m in no way guaranteeing the IRS will interpret the law this way. But the worst that can happen if you reject the subsidy now is that through some convoluted interpretation of the law the IRS determines you still don’t qualify even though you paid premiums that put your MAGI in the qualifying range. And of course you wouldn’t have qualified anyway, so you have nothing to lose by trying.


Avoiding Penalties on Retirement Account Distributions

March 20, 2014

If you had to take money out of a retirement account last year, the IRS provides some tips and general info on retirement account distributions that I’ve included below.

However, if you’re under age 59 1/2* and had to take a pension or IRA distribution last year, make sure to look carefully for all the possible exceptions to the early distribution penalty. There are several ways to get money out of an IRA or pension without penalty even if you’re under age 59. I’ll give you a few of the more common exceptions, but to find a complete list, start with page 3 of the Form 5329 instructions or consult with a well-qualified professional.

[*If you have an employer-based plan and you’re separated from service, you can start taking distributions penalty-free at age 55 instead of 59 1/2.]

First, make sure you have a taxable withdrawal. If you’ve contributed to a Roth IRA, or made non-deductible contributions to a Traditional IRA (or the equivalent employer-based plans), then part or all of your contribution might be tax-free. With Roth IRA distributions, all of your distributions are tax- and penalty-free until you’ve distributed an amount equal to your contributions to the plan. (If you’ve converted Traditional IRA money to a Roth, you’ll have to wait five years before withdrawing these funds without a penalty.) With Traditional IRAs, the formula is more complicated…basically a portion of your distribution is non-taxable based on the portion of your IRA value that comes from non-deductible contributions. See Form 8606 for the details of that calculation. The amount of your distribution that is tax-free will also be penalty-free.

Once you’ve determined some or all of your distribution is taxable, you’ll want to start looking for exceptions to the early withdrawal penalty. Some of the most common ways we find to avoid these penalties relate to education and medical expenses. Unemployed individuals are generally able to avoid the penalty for amounts equal to what they pay for health insurance. And if you had major medical expenses (greater than 7.5% of your income), you may be able to exclude part of these costs from penalty as well.

Students are able to avoid the penalty for amounts equal to what they pay for qualified education expenses. And here’s a little known twist on education…if you’re at least a half-time student, you can include an allowance for room and board in your “qualified education expenses”–even though room and board is usually not considered an education expense for most purposes. Your school’s financial aid department should be able to help you determine the official room and board allowance for your school. (Note that these apply whether the student is you, your spouse, or a dependent.)

If you’re considering a withdrawal, and considering a home purchase, be aware that there’s a $10,000 exception for qualified “first-time home buyers” (which includes taxpayers who haven’t owned their home in the last two years). This exception can be used by both spouses, so it can be used to exclude $20,000 from penalty on a joint return. This exception can be used once in your lifetime. Of you might be able to take advantage of an exception that applies to a series of substantially equal payments made over a series of years. The payments must last at least 5 years or until you reach age 59 1/2, whichever is later, so this requires careful planning.

Be aware that some of these exceptions apply to individual retirement accounts like IRAs, some to employer plans like 401k’s, and some apply to both types of plans. Before applying any of these exceptions, or taking any action based on the intent of applying any of these exceptions, make sure you do your homework or consult a professional.

And without further ado, here’s what the IRS had to say on the topic:

Some taxpayers may have needed to take an early distribution from their retirement plan last year. The IRS wants individuals who took an early distribution to know that there can be a tax impact to tapping your retirement fund.  Here are ten facts about early distributions.

  1. Payments you receive from your Individual Retirement Arrangement before you reach age 59 ½ are generally considered early or premature distributions.
  2. Early distributions are usually subject to an additional 10 percent tax.
  3. Early distributions must also be reported to the IRS.
  4. Distributions you rollover to another IRA or qualified retirement plan are not subject to the additional 10 percent tax. You must complete the rollover within 60 days after the day you received the distribution.
  5. The amount you roll over is generally taxed when the new plan makes a distribution to you or your beneficiary.
  6. If you made nondeductible contributions to an IRA and later take early distributions from your IRA, the portion of the distribution attributable to those nondeductible contributions is not taxed.
  7. If you received an early distribution from a Roth IRA, the distribution attributable to your prior contributions is not taxed.
  8. If you received a distribution from any other qualified retirement plan, generally the entire distribution is taxable unless you made after-tax employee contributions to the plan.
  9. There are several exceptions to the additional 10 percent early distribution tax, such as when the distributions are used for the purchase of a first home, for certain medical or educational expenses, or if you are disabled.
  10. For more information about early distributions from retirement plans, the additional 10 percent tax and all the exceptions see IRS Publication 575, Pension and Annuity Income and Publication 590, Individual Retirement Arrangements (IRAs). Both publications are available at IRS.gov or by calling  800-TAX-FORM (800-829-3676).

Is the “simplified” home office deduction right for you?

March 6, 2014

One of the more complicated pieces of the tax code that people commonly encounter is the home office deduction.

But last year the IRS announced it will offer a very simplified option for taking the home office deduction. As I’ll explain, this option will be very beneficial for most home-owners, especially in low cost areas. On the other hand, most renters, especially renters in expensive areas, will want to pass on this option. (Fortunately, the simplified option is just that, an option. You can still calculate your home office deduction under the old rules if you prefer.)

First, a quick background. The home office deduction is available to anybody who uses a portion of their home regularly and exclusively for business purposes. This part hasn’t changed.

Under the old method, the amount of the deduction was calculated by finding the ratio of the square footage of the home office to the entire square footage of the home. This ratio was then multiplied by various expenses related to maintaining a home such as utilities, insurance, mortgage interest, rent, etc. In addition, there are various instructions related to which expenses are always deductible, which expenses are only deductible to the extent of business profits, and so forth.

Under the new method, any area that meets the definition of a home office is eligible for a deduction of $5 per square foot, up to a maximum of 300 square feet (or $1500). So, for example, if you use a 200 square foot room as a home office during the tax year, you can deduct $1000 as a home office expense. This rule takes effect for tax year 2013.

Homeowners can still deduct the full amount they pay for mortgage interest and real estate taxes on Schedule A. Homeowners no longer deduct depreciation, which means no longer having to track depreciation over time and add that depreciation to income when the home is later sold. For these reasons, many homeowners will likely benefit from using this simplified method. In addition to fewer record-keeping hassles, many homeowners will actually get a larger deduction overall when considering that mortgage interest and real estate taxes will still be fully deductible. This won’t be true in every case, particularly if you pay a lot for utilities, home insurance, or other expenses that aren’t otherwise deductible. But as a general rule, if you own your home, you might want to consider using the simplified method.

For renters, on the other hand, you’ll probably want to continue tracking what you pay in rent and other costs so you can keep using the standard method. The reason for this is simple — you usually can’t deduct rent unless it’s a home office expense. So, let’s say you rent in even a low-cost area where you pay only 50 cents per square foot in monthly rent (this works out to $750 per month for a 1500 square foot home, just to give you an idea). Even at this rate, you’re paying $6 per square foot each year in rent alone. Plus you’re probably paying utilities on top of that, and maybe even insurance and some other costs as well. So being able to deduct $5 per square foot isn’t a particularly good deal for you. And if you’re in a high-rent area, like the SF Bay Area, you’re probably paying at least $1 per square foot each month, or $12 per year, so taking a deduction of only $5 per square foot doesn’t make much sense.

It’s a common trade-off in the tax world. Everybody claims to want simplification. But the downside to simplification is some people pay more and some pay less. And not many people like simplification if it means they pay more in tax. Fortunately in this case, every taxpayer has the choice. If taking the simplified option will mean a much smaller deduction for you, then keep doing things under the old method. But if you can save money, or even come out close to even, then your tax return will be getting a little simpler in 2013.