Bulletins

Maximize Medical Expense Deductions Under the Tougher New Rules

by Michael R Gohde, CPA, PFS

Dear clients and friends,

Before this year, you could claim an itemized deduction for medical expenses paid for you, your spouse, and your dependents to the extent those expenses exceeded 7.5% of AGI. In addition, there were no tax-law limits on the amount you could contribute to an employer-sponsored healthcare flexible spending account (FSA) arrangement. That was then. This is now. The rules have changed for the worse for 2013 and beyond. Thankfully, however, there are still some healthcare-related tax breaks on the table.

New Higher Threshold for Itemized Medical Expense Deductions

The old-law 7.5%-of-AGI hurdle for medical expense deductions was hard enough to clear. Now, pursuant to the 2010 Affordable Care Act (ACA), a stricter 1O%-of-AGI threshold applies to most individualseffective for 2013 and later years.

Exception for This Year. If either the client or the client's spouse will be age 65 or older as of 12/31/13, the unfavorable new 1O%-of-AGI threshold will not take effect until 2017. Apparently, filing a joint return is not necessary to take advantage of this exception based on the age of one's spouse. Until 2017, the familiar 7.5%-of-AGI threshold will continue to apply to folks in this situation.

Exceptions for Next Year and Beyond. If the client or spouse will turn age 65 in 2014, the new 1O%-ofAGI threshold applies for 2013 but not for 2014-2016 (the old-law 7.5%-of-AGI threshold will apply for those years). If client or spouse will turn 65 in 2015, the 1O%-of-AGI threshold will apply for 2013 and 2014 but not for 2015 and 2016 (the 7.5%-of-AGI threshold will apply for those years). If client or spouse will turn 65 in 2016, the 1O%-of-AGI threshold applies for 2013-2015 but not for 2016 (the old-law 7.5%-of-AGI threshold will apply for that year). [See IRe Sec. 213(a) and (0.] The new 1O%-of-AGI threshold applies to everyone after 2016.

Strategy: Concentrate Medical Expenditures in Alternating Years

Many individuals have flexibility regarding when certain medical expenses will be incurred. These folks may benefit from concentrating expenses in alternating years. That way, an itemized medical expense deduction can be claimed every other year, or every third year, or whatever-instead of never.

Example: Fritz, age 50, expects his AGI to be about $80,000 both this year and next year. Before 12/31/13, he pays $13,000 of uninsured medical expenses to cover an elective surgery, have some expensive dental work done, buy new glasses and contact lenses, and pay for prescription drugs. Next year, Fritz expects to have only $3,000 of uninsured medical expenses.

On this year's return, Fritz can claim a $5,000 itemized medical expense deduction ($13,000 minus $8,000 for the 1O%-of-AGI threshold). Next year, he won't be entitled to any deduction. If Fritz had simply spread the two-year total of $16,000 of medical expenses evenly over 2013 and 2014, he would not be entitled to any deduction in either year.

New $2,500 Limit on Healthcare FSA Contributions

Before this year, there was no tax-law limit on contributions to employer-sponsored healthcare FSAs (although many plans imposed their own limits). Amounts contributed to an FSA are subtracted from the employee's taxable salary. Then the employee can use the FSA money to reimburse himself or herself for qualified medical expenses. This drill allows the employee to pay for annual medical expenses with pre-tax dollars, even if the employee could not come close to clearing the applicable AGI threshold for itemized medical expense deductions.

Effective for 2013 and beyond, the maximum annual FSA contribution is capped at $2,500, thanks to another change included in the 2010 healthcare legislation. [See IRe Sec. 125(i).] However, the new contribution limit does not change the fact that your clients should take full advantage of company FSA plans when they are offered.

Strategy: Use Married Filing Separate Status If It Helps

It is sometimes beneficial for married individuals to file separate returns- using Married Filing Separate (MFS) status- when they have disproportionate amounts of medical expenses. This is especially true if the spouse with higher medical expenses also has lower AGI. By filing separately, one spouse may be able to clear the applicable AGI threshold for his or her expenses even though the threshold could not be cleared with a joint return. Note that using MFS status may not do much good for residents of community property states, because their income and deductions (including medical expense deductions) generally must be split 50/50 for federal income tax purposes. See PPC's 1040 Deskbook for details on when using married filing separate status can be helpful.

Don't Overlook Deductions for Medical Expenses Paid for Supported Relatives

Medical expenses paid for a taxpayer's dependent, such as a parent or grandparent, can be added to the taxpayer's own expenses for itemized medical expense deduction purposes.

For a person (other than a qualified child) to be the taxpayer's dependent, the taxpayer must pay over half of that person's support for the year (IRe Sec. 152). If that test is passed, the taxpayer can include medical expenses paid for the supported person-even if the taxpayer cannot claim a dependency exemption deduction for that person. (You generally can't claim a dependency exemption deduction if the supported person files jointly or has gross income in excess of the dependent exemption amount for the year- $3,900 for 2013.) While the taxpayer must still clear the applicable AGI threshold to claim an itemized medical expense deduction, including a supported person's expenses in the pot can really help.

Warning: Medical expenses are deductible only by the taxpayer who actually pays them. Thus, taxpayers claiming medical expenses paid for a dependent must pay the expense directly to the medical provider rather than the dependent. Furthermore, large medical bills for parents or persons other than dependent minor children should be paid directly to the medical service providers (e.g., doctors, hospitals, etc.) to avoid taxable gifts that are subject to gift tax or reduce the payer's applicable credit amount. Amounts paid directly to medical service providers are not taxable transfers.

Don't Overlook Deductions for Long-term Care Insurance Premiums

Qualified long-term care policies are considered health insurance. Therefore, premiums paid for qualified policies are treated as medical costs for itemized medical expense deduction purposes. As such, they can help the taxpayer clear the applicable AGI hurdle. However, the maximum amount that can be treated as a medical expense for 2013 is the lower of the actual premium amount or the age-based limit shown in the following table. These age-based limits are adjusted annually for inflation.

Age at 12/31/13

Max Amount Treated as Medical Expense

40 and under

$360

41 to 50

680

51 to 60

1,360

61 to 70

3,640

Over 70

4,550

Self-employed Folks Can Usually Claim Above-the-line Deduction for Health Insurance Premiums

Self-employed folks who pay their own medical and dental insurance premiums are generally allowed to deduct these costs above the line on page 1 of Form 1040 [IRC Sec. 162(1)]. This rule is helpful because you need not itemize to benefit from an above-the-line deduction. Unfortunately, that's about the end of the good news. In general, the taxpayer's only recourse for other out-of-pocket medical expenses (other than health premiums) is claiming an itemized deduction when those costs exceed the applicable AGI threshold.

Conclusion

Thanks to the ACA, the federal income tax treatment of out-of-pocket medical expenses has taken a turn for the worse. However, your clients' tax results can often be improved by planning ahead for medical expenditures (to the extent possible) and taking advantage of employer-sponsored healthcare FSAs (when available).

Very truly yours,

Michael R. Gohde, CPA
Daniel A. Kosmatka, CPA, PFS, CFF
Dennis W. Donnelly, CPA