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How Congress Might Tax Your Health Benefits

Jun 08, 2009

 taxes

If you work at a company that reimburses employees for joining a gym, you pay income taxes on the value of that perk. If you get life insurance through work, there’s a good chance that you pay taxes on a portion.

Health benefits could be next. Lawmakers are considering taxing them to help pay for ambitious plans to overhaul the U.S. health system, estimated to cost more than $1 trillion over 10 years. There’s a lot of money at stake: Because health benefits are excluded from payroll and income taxes, the U.S. Treasury lost out on $226 billion in 2008, according to the Joint Committee on Taxation. In an estimate circulating this week, the committee says taxing workers' health benefits above a certain threshold could bring in $418.5 billion over 10 years.

Politically, it’s not an easy sell. Polls show the public isn’t happy about the idea. For the most part, neither are businesses, which worry about the hassle of administering and explaining a new tax, and the potential exodus of young, healthy workers from coverage, which would drive up premiums for those who remain, says Blaine Bos, a principal with the benefits firm Mercer.

Chart: 2008 Tax Savings By Income

Tax Savings Chart

Pros and Cons of Altering the Insurance Tax Exclusion

Supporters say changing it could:

  • Slow premium cost growth by encouraging less-expensive health insurance.
  • Provide financing needed for a health overhaul bill.
  • End the advantage of those who get health insurance through their jobs tax-free over those who buy insurance on their own, who don’t.

Critics say changing the exclusion could:

  • Increase the number of uninsured, if workers or employers drop coverage.
  • Result in higher deductibles or otherwise less-generous insurance.
  • Penalize people whose policies cost more simply because they work for small companies, live in high-cost areas or have a preponderance of sickly co-workers.

There’s also “a lurking fear that the whole basis of employer-sponsored health insurance system may be at risk if we start fooling around with the tax exemption,” Bos said.

President Barack Obama has said he shares that concern, and during his campaign strongly opposed the idea of eliminating the tax. But Senate Finance Committee Chairman Max Baucus said last week that Obama indicated a willingness to consider some modification in the tax rules when he met with Democratic senators.

How would all this affect you? Currently, workers who get health insurance from their employers don’t pay income or payroll taxes on the cost of the policy. Self-employed people can deduct the cost of their insurance premiums. But workers who buy their own policies because they don’t get coverage through their jobs generally don’t get the tax break.

Ideas for changing current policies fall into three broad categories: Taxing health benefits above a certain dollar amount, taxing only wealthier people or replacing the tax break with a tax credit.

OPTION ONE: Cap the tax break

This would tax workers on the portion of their health benefits that exceed a set amount. Determining that benchmark is tricky. The higher it is, the less revenue government would collect.

The benchmark could be the national average premium for comprehensive policies. Those policies currently run on average $4,704 a year for single workers or $12,680 for family coverage, according to an annual survey of employers by the Kaiser Family Foundation. (KHN is part of the foundation.)

Workers with policies priced higher than those amounts would be taxed on the difference. Those with premiums below the benchmark would owe nothing. About 48 percent of workers with family health insurance currently have a policy with premiums at or above the national average, according to the Kaiser survey.

Some fairness issues arise. For one thing, insurance premiums vary around the country, reflecting local costs, state requirements and other factors. So workers in some areas would pay more in taxes. Small companies and those with a disproportionate number of older or sicker workers generally also pay more for insurance.

“Does it make sense to say you will pay more if a co-worker gets hit by a car?” asked senior research associate Stan Dorn of the Urban Institute during a panel discussion of the tax issue held last week.

Dorn suggests another way to set the benchmark: Tie it to a measure of the policy’s value – what the insurer actually pays out for claims. The benchmark could be set at, say, policies that pay 80 percent or 90 percent of approved medical claims. Less generous plans would not be taxed.

The joint committee estimate assumed the benchmark was set at the value of one of the most popular plans offered to federal employees.

IMPACT:

How much you pay depends on your tax bracket and where lawmakers set the benchmark. Tax estimates are based on the total cost of the policy, even if you pay part of the premiums. That’s because workers’ contributions to the premiums are generally tax exempt.

If you earn $50,000, your employer offers a health policy costing $3,500 a year and the benchmark is $5,000, you would not owe any additional taxes.

On a $6,500 policy, you would owe taxes on an additional $1,500, the difference between the benchmark and your plan’s cost, which would be considered income. In the 25 percent income tax bracket, that would amount to $375. If Congress also adds taxes for Social Security and Medicare, you’d owe another $115. States are likely to tax the income, too.

A worker earning $180,000 would be in the 33 percent tax bracket and owe $495, plus another $115 if Social Security and Medicare taxes are included.

For a worker who is self-employed, the impact is not clear. Lawmakers may consider them employers — and allow them to continue deducting health insurance costs as business expenses. Or the self-employed may, like workers, face taxes on all or part of those premiums.

Capping the tax break on a national premium benchmark and indexing it to the consumer price index could bring in $583.5 billion over 10 years, according to an analysis by the Lewin Group, a consulting firm that is part of Ingenix, a subsidiary of UnitedHealth Group.

OPTION TWO: Tax the rich

This option would tax only those with bigger salaries, higher-cost benefits or a combination of the two. Lawmakers would pick a premium benchmark, but the tax for policies above that amount would apply only to those with higher incomes. The exclusion could be dropped entirely for workers who earn more than a certain amount, or phased out as income rises.

This idea holds some sway with labor unions, which oppose the tax based on premiums, as well as some economists and lawmakers.

IMPACT

The income threshold is key. The policy options paper released by the Senate Finance Committee suggested several scenarios, including taxing all or part of the health benefits of single filers with incomes above $200,000 and couples earning more than $400,000.

If lawmakers choose to completely eliminate the tax exclusion for workers at those income levels, a single person earning $200,000 a year with a policy close to the national average of $4,704 a year would owe an additional $1,552 in federal income tax. A married couple earning $400,000 with a $12,680 policy would owe $4,438.

Still, taxing only the wealthy would not bring in nearly as much money as option one. The Lewin report, assuming a gradual phase out of the exclusion for people earning $250,000 to $500,000 and then complete elimination of the tax break for those with more than $500,000 in income, estimates revenue of approximately $114 billion over 10 years.

To generate more revenue, lawmakers could drop the income threshold for taxation, says Jon Gruber, professor of economics at the Massachusetts Institute of Technology. The joint taxation panel did just that in a second estimate that considered taxing a portion of the health benefits for single filers earning more than $100,000 and couples above $200,000. That would bring in $162 billion over 10 years.

OPTION THREE: End the tax break

A group of conservative Republicans has introduced a bill that would tax workers' health benefits but provide a tax credit of $2,290 for individuals and $5,710 for families. Another bill, co-sponsored by Sen. Ron Wyden, D-Ore., and Sen. Robert Bennett, R-Utah, would also tax benefits, but provide a new standard tax deduction of $6,025 for individuals and $15,210 for families, plus $2,000 per child. The deduction phases out for higher income workers. The bill would also require employers to boost wages by the same amount as they would have paid in health benefits. The Senate Finance Committee is studying proposals that would convert the tax break into a credit, deduction or a combination of the two.

IMPACT

Under the Republican bill, if you’re a single worker paid $50,000 and covered by a $3,500 health insurance policy you would pay $875 in new taxes. But you’d get a $2,290 refundable tax credit. Net result: you’d have $1,415 to put toward your premium cost or into a special account earmarked for medical costs.

A couple earning $60,000 with a $10,000 family policy would owe $1,500 in taxes, but receive a $5,710 tax credit.

Last year, the Congressional Budget Office analyzed a similar proposal that would eliminate the tax break, replacing it with a refundable credit. The credit would begin to phase out starting at income levels of $80,000 for individuals and $160,000 for families. Over 10 years, that plan would generate an additional $606 billion, the CBO estimated.

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