As the end of the year comes and goes, most people’s thoughts turn toward holidays, parties, and gifts. But the winter months are also a good time to go back over the past year’s financial records in search of ways to reduce the taxes you have to pay. In particular, there are several ways to use your medical expenses to keep some of your money in your own pocket. Read on to learn how to save money on taxes from experts in the field.
One way is to deduct medical expenses as part of the itemized deductions you can take on your federal tax return. The medical expense deduction should not be confused with the “standard deduction,” which is a set amount that people can deduct from their taxable income if they don’t itemize their deductions. There are a wide variety of expenses that can be counted toward the medical expense deduction, and it pays to know just what qualifies as a medical expense.
Another way to reduce your taxable income is by contributing to a flexible spending account or a health savings account. Such accounts allow you to set aside money tax-free to be used for medical expenses.
Both the medical expense deduction and the two types of accounts mentioned above can help lighten your tax burden. But as with most tax-related issues, there are a number of steps you must go through to determine whether you qualify, and whether these strategies will save you money.
Before looking more closely at the medical expense deduction, it is important to understand just what a deduction is, and how it differs from a credit. “Deductions reduce your gross income, which is the starting point for calculating taxes,” says Nancy Lyman, an enrolled agent with the firm of Stevens Wilcox Potvin Cassidy & Jakubowski in Rutland, Vermont. “A credit is a dollar-for-dollar reduction in taxes owed.” So, for example, if a person’s yearly gross income were $50,000, a $5,000 deduction would mean that he would be subject to tax on only $45,000 of his income. A $5,000 credit would reduce by $5,000 the amount of income tax he had to pay. There are currently no credits related to medical expenses — only deductions.
Defining “medical expense.” If you are considering taking a medical expense deduction, you need to know what qualifies as a medical expense. For tax purposes, medical expenses are costs related to the “diagnosis, cure, mitigation, treatment, or prevention of disease.” Costs related to “treatments affecting any part or function of the body” are also considered medical expenses.
What does this mean in practical terms? “Generally, to be deductible an expenditure must be for something related to a specific disease and not just to make you feel better,” says James Ivers, JD, LLM, ChFC, professor of taxation at The American College in Bryn Mawr, Pennsylvania. “The condition must affect a specific function or structure of the body. The [expenditure] can be related to a condition that results in disability or disfigurement. However, the cost of cosmetic surgery that is not related to a disease, condition present at birth, or physical injury is generally not deductible.”
The medical expenses eligible for deduction are only those that you pay for out-of-pocket to treat yourself, family members, or other dependents who qualify. (More information on whose expenses qualify can be found in Publication 502 from the Internal Revenue Service, or IRS. See Useful IRS Publications) That means that any charges for a doctor’s visit that are covered by your insurance company cannot count toward a deduction (but a copayment for the visit could).
The tax year in which medical expenses are deductible depends on when you pay them. If you see your rheumatologist in December 2010 but aren’t billed until January 2011, then you would have to wait until you file your 2011 tax return to claim the tax deduction. According to the IRS, you have paid a bill when the check is mailed, when a credit card charge is made, or when you hand over cash — not when the service is rendered. In the case of payments made by phone or online, payment is considered to have been made when the account statement says it was made. This may or may not be the same day you called or went online to make the payment.
The medical expenses that can count toward the deduction are many and far-reaching. Among the more obvious are visits to the doctor or dentist, prescription drugs (although drugs imported from foreign countries, including Canada, are specifically excluded), and laboratory fees. However, over-the-counter drugs, with the exception of insulin, are not eligible.
You can also include the cost of transportation to and from the office of a health-care provider. If you take an ambulance, taxi, bus, or other form of public transportation, you can include the entire cost of the trip. If you use your personal vehicle, you can use the cost of gas, oil, tolls, and parking, or you can us the standard amount per mile that you are allowed to include. This amount changes every year. (For 2012, it is 23 cents per mile.)
If you need to get treatment far from your hometown, lodging can count toward the deduction if the trip is “primarily for and essential to” medical care provided by a doctor in a licensed hospital or its equivalent. The lodging, according to the IRS, cannot be “lavish or extravagant under the circumstances,” and there can be “no significant element of personal pleasure, recreation, or vacation” while away from home. A person who accompanies you can also be included. The amount that can be claimed is capped at $50 a night per person.
The list of eligible expenses is long and includes many expenses you may not have considered. “Some often overlooked things include health insurance premiums if they are paid in after-tax dollars, something your employer’s human resources department can tell you,” says Melissa Labant, JD, CPA, CFP(R), tax manager for the American Institute of Certified Public Accountants in Washington, DC. “Visits to the eye doctor, prescription sunglasses and contacts, dental exams, and dentures are other things that most may not think about counting.”
Another eligible expense that is often overlooked is the fee for admission to (and the cost of transportation to and from) a medical conference. This applies only if the topic of the conference is related to your chronic condition or that of your spouse or dependent, and if you spend the majority of your time at the conference attending sessions offering medical information. Meals and lodging are not eligible for deduction when you attend a conference.
Medically related home improvements. If you make any changes to your house or car that are related to a medical condition, you should be able to count the costs toward the medical deduction. For example, if you install ramps for a wheelchair, widen doorways, make necessary changes to plumbing fixtures (for example, to make them easier to grip), or even buy special mattresses, you may be able to include these expenses.
Some of these improvements may increase the value of your house. In this case, the increase in value must be subtracted from the cost of the improvement. Only the difference is deductible. If you have any questions about whether a proposed home improvement would be eligible for deduction, talk to a tax professional or look at the IRS publication on medical expenses (see Useful IRS Publications).
What’s most important is that, to be eligible for deduction, any home-improvement expense must be directly related to a medical condition. “The basic principle when looking at some of these more exotic expenses is whether [the expense] is to improve the results of a specific disease and not just for general health,” says Ivers. “Although not entirely foolproof, getting a doctor’s prescription indicates that someone other than the taxpayer has concluded there is a link between the disease and what is being deducted. This can be the physician’s professional judgment because there is no specific requirement that the expense be backed up by clinical trials.”
Still, the devil is in the details when it comes to getting a home-improvement expense deducted. “I cannot stress enough that these kinds of deductions are very fact-specific,” says Labant. “The person down the street getting a tax benefit from putting in a spa doesn’t automatically mean that you can, too. Their arthritis may be worse.”
When pulling together the information for this tax season, don’t forget that you can include the expenditures of your spouse and dependent children. If you are recently divorced, if you have adopted a child in the last year, if someone in your household has died, or if you are looking to deduct the expenses of another person as a dependent, refer to the appropriate IRS publication or a tax consultant for advice.
Calculating the deduction
After gathering together all of your information and totaling up your eligible medical expenses for the year, the next step is to do some calculating. First, you must know your adjusted gross income (AGI), which is your total yearly income minus a few specific deductions such as interest on student loans and some business expenses, which are taken before the itemized or standard deductions discussed below. (A full list of AGI deductions can be found on the first page of the IRS’s 1040 form. The deductions are explained in detail in the 1040 instructional booklet.) Medical expenses can be deducted only if they exceed 7.5% of your AGI — and only the difference between the two figures can be deducted. If, for example, your AGI is $40,000, the “7.5% floor” for medical deductions is $3,000. In this case, if you have $3,500 in eligible medical expenses, you can claim a medical expense deduction of only $500.
Under the recently passed health-care reform law, the 7.5% floor is slated to rise to 10% in tax year 2013. For people who are 65 and older, the floor will remain at 7.5% through tax year 2016. (Note, however, that if you must pay the alternative minimum tax, the medical deduction floor is already 10%.)
If you can’t yet figure out your 2012 AGI, you could use the figure from 2011’s tax form as a base. If you have had changes in your life that resulted in a much higher or lower income in 2012, make appropriate adjustments before estimating your AGI and calculating what your deduction floor might be this year.
Are your eligible medical expenses greater than your 7.5% floor? If so, then you will want to consider claiming them as itemized deductions. But first, you will have to consider whether taking the standard deduction makes more sense.
Itemizing versus the
Most taxpayers are entitled to a yearly deduction known as the standard deduction. The standard deduction in tax year 2012 is $5,950 for a single person or married but filing separately, and $11,900 for married people filing joint returns or for qualifying widows or widowers. There are additions to the standard deduction for people who are 65 or older or are blind.
Instead of taking the standard deduction, some people are able to lower their taxable income even further by itemizing deductions. Expenses frequently itemized include state and local taxes, mortgage interest, and money given to charity. For a medical expense deduction to save you money, it and all of your other itemized deductions must add up to more than the amount of the standard deduction. (See To Itemize or Not to Itemize? for help deciding between the two options.) “The AGI floor is only part of the test,” says Mark Steber, chief tax officer for Jackson Hewitt Tax Service in Parsippany, New Jersey. “You also need to look at other deductions, such as local and state taxes paid, the amount of interest paid on a mortgage for your residence, and charitable contributions. If all of those and the medical deduction are greater than the standard deduction, then you should itemize them on Schedule A. Otherwise, just take the standard deduction and be done with it.”
FSAs and HSAs
If you are employed, a health flexible spending arrangement (FSA) — commonly called a flexible spending account — is another way to lower your tax burden. An FSA allows you to put aside a certain amount of money at the beginning of the year to use for qualified medical expenses. The money is taken from your paychecks incrementally throughout the year. Then, when you spend money on a medical item or service, you submit the receipt to your FSA administrator to be reimbursed. FSA debit cards, which have the FSA money already on them, are becoming more common and eliminate the reimbursement process.
Because the money for the FSA is taken out of your paychecks in pre-tax dollars, it is completely tax-free. For tax purposes, it is almost as if that money never existed. Some employers may match their employees’ contribution for an additional benefit. At the moment, there is no limit on the amount an employer can allow you to put into an FSA each year, but starting in tax year 2013, the yearly limit will be set at $2,500.
“All other things being equal, the FSA has the advantage [over the medical deduction] of not being subject to the 7.5% floor for deduction medical expenses,” says Ivers. “You also don’t have to worry about filling out an additional form on your tax return.”
The FSAs have one major drawback: Any money not used by the end of the tax year is not refunded. Ask your employer if your plan allows any extension of time into the new year. In most cases, FSAs are a “use it or lose it” proposition.
It used to be that most over-the-counter medicines were an eligible expense under an FSA. However, now only prescription drugs are allowed. As with the medical expense deduction, eye and dental examinations, along with prescription glasses and dentures or crowns, are qualified expenses.
If you are able to estimate how much you will spend on health-related items in a given year, an FSA can be a very good choice. “These are terrific tax benefits,” says Steber. “I tell people that if FSAs are available through their employer and they do not take advantage of them, they are missing out on some very low-hanging tax benefits. Once you select how much you want to put in the account, it is a 100% complication free benefit.”
For some people, a health savings account (HSA) is another good way to put aside money tax-free for medical expenses. HSAs are similar to FSAs, but with some notable exceptions. First, whereas anyone who is employed (even people without health insurance) can enroll in an FSA offered by the employer, only people with high-deductible health insurance plans can enroll in an HSA. In 2013, a high-deductible health plan is defined as having a minimum deductible of $1,250 for a single person or $2,500 for a family. Also, you enroll in HSAs through approved companies such as banks or insurance providers, though many employers will also help employees set up an HSA.
The major advantage of HSAs over FSAs is that money put into them can accumulate and be carried over from year to year. Also, because HSAs are not tied to an employer, they are not affected if you change jobs or lose your job. Qualified medical expenses for HSAs are similar to those for FSAs, and as with FSAs, over-the-counter drugs were not be eligible starting in 2011. For 2013, the yearly contribution limit for an HSA will be $3,250 for a person with self-only coverage, $6,450 for a person with family coverage.
The end of the year is a good time to consider either starting an FSA or HSA or changing your contribution to the one you are already enrolled in. The research you did to determine whether you qualified for the medical deduction should give you a good estimate of what your medical expenses will be for next year. Remember to factor any late-year changes in medicines or other treatments into your calculations.
As mentioned, starting in 2013 the allowed contribution to an FSA will be capped at $2,500 a year. In general, it is important to keep track of changes as the health-care reform plan is implemented. While some of the effects of the law are already known, many others will become known only as the IRS and other government agencies write the regulations needed to actually implement the law’s many provisions.
Because tax laws don’t allow people to get two tax benefits from the same money, expenses paid with money from an FSA or HSA cannot be counted toward the medical expense deduction on your tax return. However, if you spent extra money on qualified medical expenses after depleting your FSA or HSA, and those expenses were high enough to get you over the 7.5% floor, you can count them toward the deduction.
The ins and outs of the tax codes can be confusing. All of the experts interviewed for this article say the first thing they would suggest is to go to www.irs.gov or call (800) 829-3676 to order the appropriate publications. (See Useful IRS Publications)
The next step is largely up to you and depends on how confident you are in dealing with tax issues. “My baseline advice is if you don’t feel comfortable, you should ask for professional help,” says Labant. “Some [clients] may just turn their receipts over to me, and others may only want answers to specific questions. There are thousands of cases and other findings related to just medical concerns and that makes everything so specific to the situation of the individual taxpayer.”