Some taxpayers participate in group health plans sponsored by their employers, while others purchase health insurance directly from insurers or via the marketplace facilitated by the federal government. For tax purposes, it is important to understand whether health premiums are part of pre-tax earnings or post-tax earnings, as the status of premium payments may affect a taxpayer’s total income or deductions. Fortunately, it is easy to determine if a premium is part of a taxpayer’s pre-tax or post-tax earnings.
Pre-tax premiums can be identified by reviewing an employee’s pay stub. Each stub contains important information regarding the employee’s gross salary or wages, federal income tax withheld and deductions for employer-sponsored benefits. Most employer-sponsored health plans are classified as cafeteria plans, which means employees are allowed to contribute some of their gross income to the plan before any taxes are withheld.
For taxpayers enrolled in employer-sponsored health plans, determining if health premiums are pre-tax is as easy as viewing the pay stub and looking for a column labeled “Deductions,” “Before-tax Deductions” or something similar. If a health premium appears in this column and is deducted from the employee’s gross pay before any taxes are calculated, it is a pre-tax premium.
Health premiums are classified as post-tax earnings if they are paid with a taxpayer’s net income. Gross income is the amount of money a person earns before any taxes are withheld, while net income is defined as the amount of take-home pay that is left over after any taxes other payroll deductions. If an employee with $1,000 in gross income pays $200 in federal taxes, $40 in state taxes and $76.50 in Medicare and Social Security taxes, she has $683.50 left over in net income. If any of this net income is used to pay a health premium, then the premium is classified as a post-tax premium.
If an employer deducts an employee’s health premiums after income taxes have already been calculated, the premiums are classified as post-tax. Since most employer-sponsored health plans qualify as cafeteria plans, however, this is an uncommon situation. For taxpayers who purchase coverage directly from an insurance company, the premiums are post-tax, as they are paid with the taxpayer’s net income.
Pre-tax and post-tax premiums have different effects on an individual’s tax situation. One of the major benefits of pre-tax premiums is that they reduce a person’s taxable income. If someone with $1,000 of gross income and no deductions has federal tax withheld from his pay at a rate of 20%, he would pay $200 in federal taxes, and his net pay would be $800. In this example, the employee’s taxable income is $1,000. If the same employee has $150 deducted from his pay for health coverage, his taxable income is only $850. Thus, the employer would only deduct $170 for federal taxes.
Taxpayers with pre-tax premiums get a tax break each time they get paid.
In contrast, taxpayers who pay their premiums with post-tax earnings are allowed to deduct the premiums when they file their tax returns, but only in certain circumstances. The Internal Revenue Service only allows taxpayers to itemize medical expenses, including payments for health premiums, if they exceed 7.5% of a taxpayer’s adjusted gross income.