FSAs and Medical Itemized Deduction: Only One Bite at the Apple

Q: Tax Playa, could you explain the various interactions between flexible spending arrangements (FSAs) and the catastrophic medical expense itemized deduction?
John, Charlottesville VA

A: Health insurance used to be a relatively-simple proposition: you went to work and your boss paid for it.  Now, though, there are a ton of different health account, tax advantages and disadvantages, and strategies.  John asks about the interaction of two of them, the FSA and the itemized deduction for health insurance.  I'll broaden this to talk about all of them at once...

There are a bunch of ways the tax code interacts with health care.  Let's start with a summary:

1. Health insurance benefits provided are not taxable income to the recipient
2. Employer-provided health insurance is not taxable as a fringe benefit (income and FICA)
3. Government-provided health insurance is not taxable as a transfer payment
4. The self-employed, general partners, and S-corporation shareholder-employees can take an adjustment for health insurance costs paid, but not against self-employment tax
5. Those with high out-of-pocket medical costs can claim an itemized deduction for health care, but only to the extent that such costs exceed 7.5% of AGI (10% of AGI if in AMT)
6. Employers may allow employees to pay for out-of-pocket expenses using a pre-tax (income and FICA) "flexible spending arrangement" (FSA), which is "use it or lose it" by the end of the year
7. Employers may have a "health reimbursement arrangement" in which they have an accountable plan where employees turn in medical receipts
8. Anyone with a qualifying high-deductible medical plan may set up a "health savings account" where contributions can be made tax-free; employers may also contribute to such accounts

It's enough to drive one batty.  There are so many possible interactions of these plans, that it makes it difficult to plan ahead rationally.  There are several principles that can be followed, however:

1. The worst-situated taxpayer is the one who is neither self-employed nor covered by a workplace retirement plan.  There are few tax advantages available for him besides the itemized deduction
2. The itemized deduction is pretty worthless.  The 7.5% of AGI deductible is enough to prevent all but the sickest and least-insured people from using it
3. HSAs are a great deal for those who have the money to put into them tax-free, are doing it through a workplace plan (so that premiums are also tax-free), have a nice gap between their deductible exposure and the amount they can and will contribute, are relatively young, and expect relatively-little deductible accumulation the first couple of years.  This describes most of the population not planning on getting pregnant, not old, and not dealing with chronic illnesses
4. FSAs are a great deal for those that want to have traditional health insurance for whatever reason, but would like to make the nickel-and-dime co-pays, deductibles, and co-insurance fees tax-deductible.  The "use it or lose it" feature makes this a kabuki dance every year, replete with redundant eyeglasses bought in December.  Many who are playing this game would be better off with an HSA model
5. The self-employed and general partners should consider incorporating (including as an S-corporation) in order to make their health spending pre-income and pre-employment tax
6. The uninsured or those declining employer coverage are best off getting an HSA with a high-deductible plan.  The alternative is probably being uninsured.  At least this way, your out-of-pocket expenses are tax-deductible, and you can probably accumulate health resources for a rainy day
7. Medicare-eligible people should consider taking a look at some pilot programs within Medicare Advantage that allow for high-deductible Medicare plans. At any rate, these should be attractive going forward for those used to account-driven, high-deductible coverage
8. Employers really ought to take a look at HSAs.  They allow you to slow down the growth in your health care costs and provide a defined contribution benefit to your employees.  It also shifts your health spending from subsidizing insurance companies to subsidizing your own workforce

Individual situations are different, but these are my preliminary thoughts.

Comments

[Liz]

Hello,
This past year, my son was diagnosed with a form of autism. We have him in a special preschool, which I understand is tax deductible.

Here's where it gets complicated...he was only in the school a few month in 2007, not enough to reach the 7.5% floor for the medical deduction.

However, I participated in an FSA at work. If I add the medical expenses funded in the FSA to the amount we paid out of pocket for the school, I hit the 7.5%.

Is that allowed or am I out of luck on the medical deduction because I participed in the FSA?

Thanks! Liz