Itemized Deduction for Medical ExpensesMedical expenses may be tax-deductible using an itemized deduction. Total medical expenses in excess of 7.5% of a person's adjusted gross income can be deducted as part of itemized deductions. Starting with the year 2013, the 7.5% threshold will increase to 10% of adjusted gross income.
Flexible spending accounts (FSA)Some employees may be eligible to set up a medical flexible spending account (FSA) as an employee benefit through their employer. FSA plans permit employees to save pre-tax money using payroll deductions, and then submit various medical expenses for reimbursement.
Health reimbursement accounts (HRA)Some employers offer an employee benefit whereby the employer will reimburse an employee for medical expenses. Reimbursements from an HRA are tax-free.
Health savings accounts (HSA)Individuals can set up a health savings account (HSA) either themselves or through a group plan with their employer. HSAs, like FSAs, are a pre-tax savings account. Unlike FSAs, health savings plans do not have a "use-it-or-lose-it" feature for accumulated savings. Health savings account holders can use their savings funds to pay for medical expenses on a tax-free basis.
Qualifying Medical ExpensesGenerally speaking, a medical expense will qualify for a tax deduction or tax-free reimbursement the expense is for the diagnosis, cure, mitigation, treatment, or prevention of disease, and the costs for treatments affecting any part or function of the body. The following general types of expenses qualify:
- Costs for medical services from physicians, surgeons, dentists and other medical professionals;
- Costs for medications prescribed by a medical professional
- Costs for medical devices, equipment and supplies prescribed by a medical professional (such as eyeglasses)
- Costs for health and dental insurance
- Costs for long-term care and long-term care insurance
- Transportation and lodging costs for traveling to a health care facility, including mileage for driving for medical care at a rate of 16.5 cents per mile (for 2010).
Tax Planning for Medical ExpensesIt's generally advantageous to utilize pre-tax savings plans to pay for out-of-pocket medical expenses compared to taking an itemized deduction. That's because FSA, HSA, and HRA plans hold pre-tax money, and so any medical expenses paid out of these plans represent an 100% deduction for the expense. The itemized deduction, by contrast, is at best only partially tax-deductible. Similarly anyone whose total medical expenses for the year are less than 7.5% of adjusted gross income or whose standard deduction is more favorable than the itemized deduction will find that none of their out-of-pocket medical expenses are tax-deductible.
In addition, individuals should be aware of annual limits and restrictions with FSA plans. With an FSA, employees can set aside a given amount of money pre-tax through payroll deduction. FSA funds may be forfeited if not used by the end of the calendar year. Beginning with the year 2013, the annual limit for FSA savings is $2,500. Because of this "use-it-or-lose-it" feature with FSA plans, the recommendation is to set aside just enough funds to cover expected out-of-pocket expenses such as prescription and office co-pays, eyeglasses, and so forth. FSA plans, unlike other health-related savings plans, provide savings that are pre-tax for federal income, Social Security and Medicare taxes.
Tax planning for health savings accounts is different than planning for FSA plans. Health savings accounts do not have a "use-it-or-lose-it" provision. With HSA plans, savings can accumulate and are not forfeited at the end of the year. Accordingly, HSA plans can be used to save up for large medical expenses. And some HSA plans permit account holders to invest their savings in various investment products such as mutual funds, which will produce tax-free investment income. So with HSA plans, the recommendation is to save as much as possible per year, and tap into the savings account only when needed so as to allow as much time for the compounding of interest or other investment income.