Let's start with an intro
Here’s a couple fun facts. The U.S. has what’s widely considered to be the most complicated tax system in the world. We also have possibly the most complicated healthcare system. Fun.
As you can imagine, this makes any research and discussion on tax deductions for health insurance quite complex. In fact, I found the research for this post difficult since most sources were incomplete or just plain confusing.
I’ll do my best to break down the tax angle of healthcare expenses specifically for small business owners who operate as sole proprietorships, single member LLCs, or s corporations.
Also note that I’m making an assumption throughout this blog that you, the reader, are the sole owner of your own business. We’re not discussing partnerships or the tax benefits and ramifications of non-owner employees.
Self-Employed Health Insurance Deduction
The self-employed health insurance deduction is our most common tax benefit. To understand it, we need to lay some groundwork. Generally speaking, we have business deductions, as well as two types of personal deductions. The first we call adjustments or “above the line” deductions. I’ll use the term adjustments. The second are itemized deductions.
Taxpayers get the benefit of adjustments regardless of whether they “itemize.” The self-employed health insurance deduction is an adjustment. This is, mostly, good. But, it’d be even better if it were a business deduction. Here’s why.
Small businesses actually pay two different taxes, income tax and self-employment tax. Self-employment tax is the combination of medicare and social security taxes. We calculate income tax based on our household income after deducting things like adjustments. Self-employment tax is calculated on our net business income.
Here’s an example. Assume you make $50,000 in your business. You spend $2,000 on a new computer. It’s a deductible business expense. Now, your net business income is $48,000. You calculate your self-employment tax off that number. In short, the business deduction lowers both your income tax burden and your self-employment tax.
Stated in reverse, adjustments are great because they lower your income tax liability, but they do not benefit you with regard to self-employment tax. Like I mentioned, the fact that our insurance deduction is an adjustment is mostly good. It’s still better than the limited medical deductions available to non-business owners.
Here’s how the adjustment works in an example.
Assume your business has that net income of $48,000. You have a part-time job where you earn wages of $20,000. Your total income is $68,000. Note that “total” in this context is net business income plus other income.
In our example, you pay $2,000 during the year for health insurance as a self-employed person. You also have other adjustments totaling $1,000. Total adjustments equal $3,000. You deduct that from your total income. $68,000 less $3,000 is $65,000. This is what we call your adjusted gross income (AGI). From this number, we deduct your standard deduction or, potentially, itemized deductions, afterwhich, you calculate your income tax.
How to Qualify for the Self-Employed Health Insurance Deduction
To take the deduction you must be self-employed, and you must show a profit in the business for the year. In an s corp, your deduction is limited to the amount of wages you earn from the business.
Additionally, there’s one big caveat. You may not take the deduction if eligible for another healthcare plan either through your own employer or through a spouse’s employer.
Also, note that to take a deduction, your health insurance must be a “qualified health plan.” A qualified health plan must provide an “essentials health benefits package.” These rules were created when the Affordable Care Act went into place. Since, there have been changes to the law, which have broadened the scope of qualified plans. Don’t sweat over the specifics. Just look for the stamp of approval or ask about it when you’re considering a specific health plan.
Health Insurance for S Corp Owners
If you operate as an s corp, things are a touch more complicated. The insurance must be in the name of the business and paid by the business or, if in the name of the individual, the premium must still be paid or properly reimbursed by the business. Ideally, you have the business take care of the premium. It’ll make things much simpler.
The payments are then included on your W-2 as income. However, if classified correctly, the payments should not be subject to self-employment taxes, only income taxes.
Here’s how that works. Check out the W-2 below. Boxes 1, 3, and 5 all ask for wages. Box 1 is wages for purposes of determining income taxes, box 3, is wages for determining social security taxes, and box 5 is wages for determining medicare taxes. Admittedly this always confused me. Whenever I saw W-2s, the numbers in the three boxes were the same. If someone made $80,000 each of the three boxes would show $80,000.
But this isn’t always the case. If you, as the owner of an s corp, determine that your reasonable salary needs to be $50,000, you’d run that through your payroll. See my s corp blog post for more info about this. You decide to have your s corp pay your health insurance premiums. Let’s say that’s $5,000 per year. That also goes on the W-2 as income, for income tax purposes.
Thus, your box 1 would show $55,000. And boxes 3 and 5 would only show $50,000. You’re essentially saving the income tax on the $5,000.
But hold up a second! Is this actually the best way to handle these payments? No. As you’ll learn from my s corp blog, the key to saving in an s corp is paying yourself a lower salary provided you’re meeting that “reasonableness” requirement.
With our example of $50,000 being a reasonable salary, you’d be better off paying $45,000 plus the $5,000 premium. That nets you the $50,000 total as required and helps you save more in self-employment taxes. In short, that additional $5,000 you are no longer running as salary is reclassified as a distribution saving you (probably) 15.3% in self-employment taxes, or $765.
Alrighty, so now we understand how boxes 1, 3, and 5 on the W-2 work. We’re not paying self-employment taxes on the amount not reported in boxes 3 and 5, the health insurance costs, but we are paying income taxes since it’s included in box 1.
The good news is that we can recoup the income tax on that amount as well, provided we meet the criteria outlined above. All you need to do is take the self-employed health insurance deduction on your return to recoup those tax withholdings. Remember, this is an adjustment or above-the-line deduction that decreases your adjusted gross income.
In summary, if you qualify for the self-employed health insurance deduction as a sole prop or single member LLC, you save income taxes on the cost of the premiums. If you qualify as an s corp owner, and run things correctly, you save both the income tax and self-employment tax on the cost of the premiums.
Want to learn about even more deductions that could be saving you taxes?
Download the Small Biz Tax Deduction Guide. I'll walk you through the most common deductions for small business owners so you can start saving more on your tax bill.
HSAs, HRAs, and MERPs
Yes, that’s a lot of acronyms, but hang with me. Each of these health plans fall into the category of Medical Reimbursement Plans (MRPs). Just like the name indicates, MRPs are plans that reimburse or help employees - or small business owners - cover their healthcare costs. Each of these are typically paired with high-deductible health plans (HDHPs).
As you can imagine, HDHPs are typically less costly than traditional health plans. They can be a good option for relatively healthy individuals.
Health Savings Accounts (HSAs)
An HSA is like a little piggy bank. You stash away cash in the HSA to cover future healthcare costs. The best part, you don’t pay taxes on the money before it hits your piggy bank, and the tax person doesn't come knocking when you take the money out either, provided you’re meeting the IRS requirements.
The big requirement is that - if you use the funds - you’re using them only to pay for qualified medical expenses. Most legitimate healthcare costs will qualify. If you’re unsure give it a Google before you go spending the money. Note that many gray area items, like massages, may actually qualify if they have been specifically prescribed by a physician.
To get started, you will want to look for an HSA-eligible high deductible health plan (HDHP).
Once you’re set up, the tax deductions are pretty simple, like the self-employed health insurance deduction, HSA contributions are taken as adjustments on the tax return. This makes things easy for all the non-s corp folks. For s corp owners the tax treatment is the same as standard health insurance costs. Contributions to the HSA are added to your income on your W-2 (box 1 only). You then take the adjustment on your tax return.
Health Savings Account Limitations
Due to the amazing tax benefits, there are limits on how much you can contribute to an HSA. In 2021, individuals may contribute up to $3,600 in one year. If your HSA covers your whole family, the limit is $7,000.
Health Savings Accounts for Retirement
Most of us don’t think of HSAs as an investment vehicle. Instead, we view them through the lens of insurance and medical expenses. However, the tax benefits make HSAs one of the most powerful tools to save for retirement.
For starters, consider how much more we generally expect to pay for healthcare in our older years.
There’s no obligation to spend your HSA funds at any point. The money in the account can grow and grow with compound interest much like a 401(k) or IRA, but the HSA actually has even better tax treatment.
For this reason, the best way to use your HSA might be to not use it at all (other than funding it of course). Instead, you can let it grow and grow while continuing - if you can afford to do so - paying out-of-pocket for your healthcare costs.
For more information on retirement savings and taxes, check out this blog post.
Health Reimbursement Arrangements (HRAs)
These are employer funded plans that reimburse employees for out-of-pocket healthcare costs. I was prepared to write a whole damn section on HRAs until it dawned on me that these are only really useful to c corps, so I’ll spare you further explanation.
Medical Expense Reimbursement Plans (MERPs)
A MERP is a type of HRA. They allow business owners to take a deduction for reimbursements made to employees. That deduction then saves the business both income tax and self-employment tax. But this is a more complicated and advanced strategy if you don’t have standard employees.
You must have an employee, other than yourself, to qualify for a MERP. The only exception to this rule is when you have a c corp, which is basically none of us. Interestly, you can hire your spouse as an employee to qualify unless you have an s corp. However, there is a workaround for these s corp owners. I recommend consulting a well qualified tax professional to get help setting that up. If you have a high income earning business, it may be well worth your trouble.
When to Start Using These Benefits
Now. That’s the answer.
With many tax strategies, we talk about when it makes sense to pull the trigger, like with forming an s corp. This topic is different. We all need health insurance. Regardless of whether your business brings in 7 figures or if you’re scratching the surface of 5 figures, health insurance isn’t a bad idea.
If you don’t have employer sponsored insurance, and don’t qualify for government subsidized insurance, go out and see what you can afford. Then, get those tax deductions.
Part of me feels as if I did a great job taking pages and pages of notes I had on this topic and synthesizing it down to only what’s useful for small business owners. I’m patting myself on the back as you read this. The other part of me feels like I’m just scratching the surface. How do you feel? What lingering questions do you have? Are there any healthcare deductions, benefits, or plans you expected to hear about? Post in my Facebook Group and let me know. I’ll do my best to answer, and you may help me supplement this post in the future.
Ultimately, you must weigh and balance tax considerations with your healthcare needs. I’d caution you to primarily focus on your healthcare needs. Don’t screw yourself in the long run to save $1,000 in taxes now. Instead, determine what your coverage options are. Do the research. Choose the best path forward. Then, capitalize on the tax savings available to you with that chosen plan.