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

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.

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