Deducting Medical Expenses for a Major Illness or Injury
TurboTax helps you understand medical expense deductions, HSA and MSA distributions, flexible spending accounts, IRA and 401(k) payouts for medical expenses, and more.
Key Takeaways
- Medical expenses are only deductible after they exceed 7.5% of your Adjusted Gross Income (AGI). If you have high expenses or low AGI, or both, you might meet this threshold.
- Money you put in a Health Savings Account (HSA), Archer Medical Savings Account (MSA), or Flexible Spending Account (FSA) can grow tax free and you can make tax-free withdrawals for medical purchases.
- You can withdraw money from retirement plans without the 10% penalty for early withdrawals if you have qualifying medical expenses greater than 7.5% of your AGI.
- If you receive benefits under a disability insurance policy and the premiums are paid with pre-tax money, the benefits are taxable. If the premiums are paid with taxed money, then the benefits are tax-free.
Medical expense deductions
Most taxpayers know that medical expenses are deductible but few of us ever actually benefit from the deduction. The catch? This deduction has two high hurdles:
- You must itemize deductions to write off medical expenses, and only about one-third of taxpayers have itemized in the past.
- Medical costs are deductible only after they exceed 7.5% of your Adjusted Gross Income (AGI). So, if your AGI is $50,000, the first $3,750 ($50,000 x 0.075) of unreimbursed medical expenses doesn't count.
Although it seems difficult to claim these deductions, there are situations when it actually works out. Mostly when:
- Your medical expenses are high, perhaps due to a serious illness or injury, or just needing braces for a couple of teenagers.
- Your AGI is low, maybe due to low taxable retirement income or being out of work for part of the year.
If you combine these two, you have a “perfect” combination for deducting medical expenses.
HSA, MSA and FSA distributions
This alphabet soup of health-saving-plans allows you to make tax-free withdrawals for medical purchases. These plans include:
- Health Savings Accounts (HSA)
- Archer Medical Savings Accounts (MSA)
- Flexible Spending Accounts (FSA)
HSAs and MSAs require that you have a high deductible health plan and are established for paying medical expenses.
- Individuals can establish these plans and most anyone can contribute to them on behalf of the account beneficiary.
- Money in these accounts can grow tax-free.
- Withdrawals for qualifying medical expenses are not subject to income tax.
FSAs are established by employers and are not required to be paired with a high deductible health plan.
- Although contributions can be made by both employers and employees, they are typically funded through payroll deductions.
- Salary diverted into an FSA and then used to pay medical bills escapes both income and Social Security taxes.
- Although there is no legal limit on how much can be set aside, most companies limit contributions to $5,000 or less per year.
To illustrate the savings, if you set aside $5,000 in an FSA, it avoids being taxed as income. It also avoids the 7.65% Social Security and Medicare tax. If your tax rate is 25%, you would save more than $1,600. Any state tax savings would make this an even better deal.
Generally, you can change the contribution amount to you FSA account once a year. So if you are expecting an increase or decrease in medical bills you can plan ahead and make a change to your contribution.
TurboTax Tip:
If you receive an insurance settlement that includes funds for future medical expenses, those funds aren’t taxable, but you can only deduct the medical expenses that exceed the award.
IRA and 401(k) plan payouts
Usually it isn’t a good idea to withdraw money from retirement plans before you retire. Sometimes you don’t have a choice when it comes to paying medical bills.
- If you are under age 59½, the 10% penalty for early withdrawals from retirement plans is waived to the extent that you have qualifying medical expenses greater than 7.5% of your AGI.
- Even if you avoid the penalty, your withdrawals will be taxed as income.
Disability insurance payments
If your condition results in your receiving benefits under a disability insurance policy, the taxability of the income depends on if the insurance premiums were paid with pre-tax or post-tax money.
- Typically, premiums paid by your employer are with pre-tax money and therefore the income-benefits are taxable.
- If you paid the insurance premiums with money that has already been taxed then benefits are tax-free.
Damages
If you receive a settlement that includes money for medical expenses you deducted in an earlier year, the amount that you deducted is taxable in the year you receive it, but only to the extent that the deduction actually reduced your taxable income.
If a settlement includes funds for future medical expenses, the amount is not taxable, but you also cannot deduct the future medical expenses except for any amount that exceeds the award.
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