People can deduct the cost of health insurance on their income tax return. Who's eligible to deduct expenses for medical and dental insurance depends partly on whether you are an employee or self-employed, and partly on whether your health insurance was paid for using pre-tax dollars or post-tax dollars.
Health insurance costs as part of the medical expense deduction. This deduction is among the itemized deductions, and total medical expenses are deductible only to the extent they exceed 7.5% of your adjusted gross income. Mathematically, this is very disadvantageous. Still, if you have significant medical expenses, adding in health insurance may help you to get over the 7.5% threshold.
Be aware, however, that employees who paid health insurance using pre-tax dollars through payroll deductions won't be able to take a further deduction for these same expenses. Or to phrase this differently, paying for health insurance as a pre-tax salary deduction is more advantageous than the itemized deduction. That's because pre-tax health benefits reduce your taxable salary, so the deduction comes "off the top," so to speak, and isn't clawed back by the 7.5% threshold. Further, health insurance premiums are deducted pre-tax for income tax, Social Security tax and Medicare tax on an employee's paycheck, making this employee benefit triple-tax free. (Quadruple tax-free if your state allows for pre-tax health insurance benefits.)
Self-employed persons take a deduction for health insurance for themselves and their family directly on their Form 1040 as an adjustment to income. This is much more beneficial than the itemized deduction, because the expense isn't limited by the 7.5% of income threshold. And for 2010 only, the self-employed health insurance deduction will reduce the Self-Employment Tax. In previous years, and starting again in 2011 and going forward, the health insurance deduction for self-employed persons will only reduce the income tax, and not reduce in any way the Self-Employment Tax.
Thus for 2010 only, self-employed persons will enjoy parity with their employee counterparts in benefiting from the triple tax-free nature of the health insurance deduction.
Alas, this particular 2010 tax break for self-employed persons has generated uncertainty. IRS Publication 535, which deals with business expenses commonly encountered by self-employed persons, has not yet been updated to reflect this one-time change in the tax laws. In fact, I recently heard from Ms. Jenny, who emailed me with the following question:
"I was reading from the IRS website that one cannot use the health insurance premium to reduce the self-employment [tax].... It is contrasting to what your article states. Do you have a link to the official documentation for this 'special rule for 2010' only to verify this?"
Jenny went on to quote from Publication 535, which informs taxpayers, "Do not subtract the health insurance deduction when figuring net earnings for your self-employment tax."
I continue to be amazed at how diligent the readers of About.com are about getting their taxes right. Taxpayers should compare multiple sources of information to make sure that their taxes are calculated correctly, and not just rely on software to make the decisions and calculations for them. So, Jenny, here's what's going on.
This change was part of the Small Business Jobs Act of 2010, which was signed into law on September 27, 2010. Section 2042 of the Small Business Jobs Act revised Internal Revenue Code section 162(l)(4) by permitting health insurance expenses to reduce net earnings for the purpose of calculating the self-employment tax for the year 2010 only. The current version of Publication 535 (as of the writing of this article) relates to the year 2009, and the PDF version of that publication states that the 2010 version will be posted soon. However, the IRS does reference this special rule for 2010 in their Instructions for Schedule SE (which is the tax form used for calculating Social Security and Medicare taxes for self-employed persons). You'll find it mentioned on page 1, column 1, under the heading What's New:
"Deduction for self-employed health insurance. For 2010, you may be able to reduce your net self-employment income by the amount of your self-employed health insurance deduction"
It's mentioned again on page 3. But very curiously, the IRS did not mention this 2010-only tax savings in their Tax Tips for March 14, 2011, which was entitled "Health Insurance Tax Breaks for the Self-Employed." That tax tip from the IRS mentioned that self-employed persons can deduct the cost of medical and dental insurance, but did not point out the additional benefit of reducing the self-employment tax.
So in summary, anyone can (potentially) deduct the cost of health insurance. Employees benefit most since health insurance premiums are deducted triple tax-free from their salary, without any of the limitations of the itemized deduction or the hassle of remembering to deduct the expense on their tax return. Self-employed types can deduct health insurance on page 1 of the 1040, which is also advantageous in avoiding the hassle and limitations of itemizing. Other taxpayers can deduct the cost of health insurance only as an itemized deduction. Being able to deduct medical and dental insurance costs is going to become an essential feature of our tax incentive system, especially since having health insurance coverage will become mandatory starting in 2014, thanks to the health care reform legislation passed back in March 2010.