Tax Treatment of Premiums and Benefits

Taxation of Medical Expense Insurance and Health Reimbursement Arrangements

Understanding the tax rules for medical expense insurance starts with knowing who pays the premium and whether that premium was deducted. If you itemize deductions on your federal return, you may deduct eligible individual medical insurance premiums as medical expenses to the extent your total eligible expenses exceed 7.5 percent of your adjusted gross income. If you are self-employed, a separate deduction may be available. You may be able to deduct eligible health insurance premiums for yourself, your spouse, and eligible family members without itemizing. This self-employed health insurance deduction is limited by the earned income from the business under which the coverage is established, after certain required adjustments, and is subject to restrictions when you are eligible for subsidized employer coverage.

Benefits that reimburse covered medical expenses under an individual policy are generally income tax-free because they pay for medical care. However, you cannot also keep a tax deduction for the same expenses. If you deduct a medical expense and receive an insurance reimbursement for it in a later year, you generally include the reimbursement in income up to the amount of the earlier deduction that produced a tax benefit. For example, if you deducted a medical expense that lowered your tax bill in year one, you generally include a reimbursement received in year two in income up to the amount of that earlier deduction, not merely the amount your tax bill decreased.

For employer-sponsored group health plans, premiums paid by an employer are fully tax deductible to the employer as a normal business expense. Employer contributions toward eligible employees' group health insurance premiums generally are excluded from employee gross income, but special tax rules apply to certain business owners and to coverage for people who are not eligible tax dependents. Benefits from an employer-sponsored group health plan are generally income tax-free when they reimburse qualified medical expenses, regardless of whether you pay your share of the premium with after-tax dollars or through an eligible pre-tax arrangement.

Many employers offer premium payment through a Section 125 cafeteria plan. Employee contributions to group health premiums made through a Section 125 cafeteria plan are paid on a pre-tax basis through salary reduction. These pre-tax premium deductions reduce the employee's taxable income for both federal income tax and payroll taxes. In addition, an employer can establish a health reimbursement arrangement. Health reimbursement arrangement contributions can only be made by the employer, and these contributions are deductible by the business. Reimbursements received by employees from a qualified health reimbursement arrangement for approved medical expenses are income tax-free.

Disability Income Insurance Taxation Rules

The tax treatment of disability income insurance follows a straightforward principle: the taxation of benefits depends on how the premiums were handled. Premiums paid by an individual for personally owned disability income insurance are not tax deductible. Because those premiums are paid with after-tax income, disability income benefits received from an individual policy paid with after-tax dollars are entirely income tax-free.

When an employer provides group disability income insurance and pays the full premium, the rules change. The premiums paid by the employer are deductible by the employer as a business expense. If your employer pays the full group disability insurance premium and the premium is excluded from your income, your disability income benefits are generally taxable. Conversely, when group disability insurance premiums are paid entirely by the employee with after-tax dollars, the resulting disability income benefits are tax-free.

Many employer-sponsored group disability plans are contributory, meaning both the employer and employee share the cost. In a contributory group disability plan, the portion of benefits attributable to employer-paid premiums excluded from your income is generally taxable, while the portion attributable to your after-tax premium payments is generally tax-free. For instance, if an employer pays 60 percent of a group disability premium and the employee pays 40 percent with after-tax dollars, 60 percent of the disability benefit is taxable and 40 percent is tax-free.

Some employers allow workers to pay their share of disability premiums through pre-tax salary reduction plans. If an employee pays their portion of a group disability premium through a pre-tax salary reduction, that portion is treated as employer-paid for tax purposes. Consequently, disability benefits attributable to pre-tax employee contributions are fully taxable as income.

Special executive arrangements also reflect these principles. If an employer pays premiums for an executive's individual disability policy and treats the payments as taxable compensation to the executive, the employer may generally deduct them as compensation, subject to ordinary business-expense rules. Because those premiums are included in the executive's taxable income, benefits attributable to those after-tax premiums are generally income tax-free. In an arrangement that shares disability insurance costs or benefits, tax treatment depends on the policy terms, who receives the benefits, and whether the premiums attributable to those benefits were paid with after-tax dollars or excluded from the insured person's income.

Business Disability Arrangements

Businesses often use disability policies to manage operational risk, and the tax rules vary strictly based on policy design and purpose. Business overhead expense insurance helps keep a company operating if the owner becomes disabled. Premiums paid by a business for business overhead expense insurance are fully deductible as an ordinary business expense. However, benefits received under a business overhead expense insurance policy are fully taxable as ordinary income to the business. In practice, business overhead expense benefits are used to pay deductible business expenses like rent and utilities, which offsets the tax liability created by the benefits. This insurance does not pay the salary or personal income of the disabled business owner.

Another critical commercial tool is the disability buyout policy. A disability buyout policy provides funds to purchase the ownership interest of a totally and permanently disabled partner or business owner. Premiums paid for a disability buyout policy are not tax deductible by the business or the owners. Because premiums are paid with after-tax money, disability buyout policy proceeds are generally income tax-free when premiums were not deducted. However, the separate sale of the disabled owner's business interest may have tax consequences.

A company may also purchase key-person disability income insurance to protect against the loss of specialized talent. In a key-person disability policy, the business is the policyowner, premium payor, and sole beneficiary. Premiums paid by a business for key-person disability income insurance are not deductible as a business expense. Consequently, benefits a business receives under a key-person disability policy are generally income tax-free when the business paid the premiums without deducting them.

Tax Rules for Long-Term Care, AD&D, and Specialized Coverage

Qualified long-term care insurance receives specific tax advantages under federal guidelines. Premiums for qualified long-term care insurance can count as medical expenses up to age-based federal limits, subject to the applicable rules for deducting medical expenses. If you claim qualified long-term care premiums as an itemized medical expense deduction, your eligible expenses must exceed 7.5 percent of adjusted gross income, though a separate deduction may be available if you are self-employed.

Benefits received from a qualified long-term care insurance policy that reimburse actual care expenses are generally received free of income tax. When policies provide coverage through alternative distribution models, different benchmarks apply. Qualified long-term care benefits paid on a per diem or other periodic basis are generally income tax-free up to the greater of a federal daily limit or eligible care costs, after accounting for other reimbursements. However, per diem long-term care benefits may be taxable to the extent they exceed both the federal limit and eligible care costs, after accounting for other reimbursements.

When an employer sponsors qualified long-term care protection, employer-paid premiums for qualified group long-term care insurance are deductible by the employer as a business expense. Employer-paid premiums for qualified long-term care insurance generally are excluded from an eligible employee's gross income, but special tax rules apply to certain business owners. However, a strict restriction applies to cafeteria plans: long-term care insurance cannot be offered as a tax-free benefit through an employer's Section 125 cafeteria plan.

Specialized coverages like accidental death and dismemberment and critical illness follow consistent after-tax principles. Accidental death and dismemberment premiums paid by an individual are not tax deductible. Lump-sum accidental death and dismemberment benefits paid to a designated beneficiary are received entirely free of income tax, and capital sum benefits paid to an insured under an accidental death and dismemberment policy for the loss of a limb or sight are tax-free. If an employer pays the premiums for group accidental death and dismemberment coverage, those premiums are deductible by the employer and excluded from employee gross income. For critical illness or dread disease policies paid with after-tax individual dollars, benefits are received free of income tax. Individual critical illness insurance premiums are not deductible as medical expenses unless the policy qualifies as medical care under the tax code.