The starting point of determining your household income for purpose of the ACA tax credit is your adjusted gross income AGI). As explained in my previous post (Part One), your household income is the combination of the AGI of the primary taxpayer and any other family members with incomes large enough to trigger tax liability, together with any tax-exempt income from interest, social security, or foreign earnings.
AGI is defined in Internal Revenue Code section 62. It is the amount remaining after subtracting various specified deductions from your gross income (or the total of all taxable forms of income). Because these various deductions can potentially reduce your income by thousand of dollars, it means that you or your family may be eligible for the premium assistance tax credit even if you have total income well above the 400% federal poverty level.
Here are some of the most common deductions enumerated in Section 62 which may effectively reduce income. Many individuals or families whose household incomes fall above the 400% FPL subsidy limits may find that they can effectively reduce their AGI and qualify for significant credits toward their insurance by simply taking advantage of deductions they may not have fully utilized in the past.
A good starting point is to look at the list of deductions on the 1040 tax form, in the section labeled “Adjusted Gross Income.”
Parents of college-age children who are close to the edge of subsidy-eligibility might want to pay particular attention to the student loan interest
and tuition and fees deductions on lines 33 and 34. [Note: Unless Congress takes action to restore or extend the tuition deduction, it will not be available to reduce income in 2014] Interest paid on qualified student loans may be deducted up to the amount of $2500. This deduction is available to parents who take out qualified loans, such as federal PLUS loans, to help finance their children’s education. At the current 6.41% interest rate for PLUS loans, that $2500 maximum would be reached with loans of $40,000 or more. Because loan payments are mostly interest in the early years of a loan, and because interest begins to run on parent loans as soon as they are disbursed, it could be advantageous for a family to take out loans for amounts they had planned to pay from other resources. Of course, in order to take the deduction, the family will also have to make the loan payments, so this approach would probably be beneficial only for larger families where the premium savings would be well in excess of that $2500. Do the math first and keep in mind that student loans are typically amortized over ten years, which may leave a continuing debt obligation in future years when other income or a shrinking household size might wipe out any possibility of subsidy eligibility.
All taxpayers might want to consider the benefits of contributing to a traditional IRA, with contribution and deduction limits up to $6500 for taxpayers over age 50. This literally is a way that you can bank your money and at the same time use the banked money to lower both your tax liability and perhaps qualify for a tax subsidy. It may be particularly attractive for individuals age 60 and over who are facing higher cost insurance premiums, as money deposited in existing IRA’s can be withdrawn without penalty after age 59 1/2. If you typically deposit to a Roth IRA – which does not provide an income-reducing deduction – you might want to hold off on making that 2014 contribution until 2015 when you have a clearer picture of your 2014 income. IRA contributions for a tax year can be made any time up to the tax filing deadline for the subsequent year, but you cannot exceed the maximum by contributing to more than one type of IRA.
Another way to bank your money and reduce AGI is to opt for an HSA-eligible plan on the exchange, and fully fund a Health Savings Account. This is a nice choice because the money you bank in the HSA can also be used to pay for out-of-pocket expenses incurred before you meet your plan’s deductible. Contribution limits in 2014 are $3,300 for an individual, $6,550 for a family, with an extra $1000 allowed for taxpayers over age 50. Keep in mind that merely buying the HSA-eligible plan is not enough to qualify for the deduction; you also must actually deposit the funds in your HSA.
Self-employed individuals may be able to achieve the greatest reduction in AGI by maximizing allowable deductions. To start with, the self-employed can automatically take a deduction for the employer-equivalent portion of your self-employment tax. This deduction is intended to put the self-employed on equal-footing with employed individuals. When you are self-employed, you occupy the dual roles of both employer and employee. The self-employment tax is meant to cover both the social security and medicare tax payroll deductions that wage earners pay, and the employer’s share of those taxes. The ability to deduct half of that insures that the self-employed are doubly taxed.
Self-employed contributions to qualified retirement funds. A self-employed person can also set up a Simplified Employee Pension (SEP) or other retirement fund and deduct contributions to such a plan from the AGI. These are the types of plans that are usually set up by employers, so that the tax deduction goes to the employer rather than to the employee. But because the self-employed occupy both the roles of employer and employee, they are allowed to simply deduct this amount from their gross income. There is a rather complex IRS worksheet to figure out the maximum annual deduction, but generally the maximum is 20% of net income from self employment. In other words, a person who owns a small business with a net profit of $100,000 may be able to set aside and deduct $20,000 into a retirement plan.
The self-employed can also deduct up to the full cost of their health insurance premiums. This is one area where the present wording of the law seems to provide an extra benefit for the self-employed, if in fact you can use the full cost of the premiums reduce AGI for purposes of subsidy eligibility. For a simple example, let’s assume a single taxpayer with an AGI of $50,000 before consideration of the self-employed health insurance deduction. If that person pays $6,000 in annual premiums ($500/month), the AGI is reduced to $44,000, rendering the individual available for a tax credit of $1,820.
Here’s the math: at $44,000, the taxpayer can be required to pay no more than $4,180 annually for the benchmark Silver plan for his age and region. If we assume that the $500 premium correlates with that plan, then the taxpayer would qualify for a refund in the amount of the difference between the premiums he paid –$6000 — and the maximum required at his income level. $6000 less $4180 is $1820.
However, let’s assume for a moment that the taxpayer actually earned $55,000, but also opted to buy an HSA eligible Bronze plan, for $500 a month, and the benchmark Silver plan premium is $600 a month. Our $55K earner is also older than age 50, so he banks $4300 ($3300 + $1000 catch up) in his HSA. The HSA deduction of $4300 combined with the self-employed health insurance deduction of $6000 is $10,300, which brings his income down to $44,700, below the 2013 400% FPL of $45,960 for a single taxpayer. At that income level, the maximum the taxpayer is required to pay for insurance is $4,247 (about $354 per month). Because the benchmark Silver plan has a premium of $600 – $7200 a year — the ACA tax credit is $2,953.
Here is an example of the way a combination of deductions for a self-employed person might stack up:
Net Income from Self Employment: $75,000
Self-Employment Tax Deduction: $ 5,298
Self Employed Health Insurance: $ 6,000
HSA Deduction: $ 4,300
Retirement (SEP) contribution: $15,000
AGI After Deductions: $44,402
A word of caution: The double-benefit from being able to deduct 100% of health insurance premiums in order to reduce AGI, and then used the same deduction to qualify for a substantial tax credit seems to fly in the face of the way the tax law usually works. Generally the laws are written to prevent taxpayers from applying the same expense to benefit in multiple ways. For example, there is a clear provision that if you opt to pay medical expenses from your HSA, you cannot also claim those same expenses as a medical deduction on your schedule A. But there is nothing written in the law to prevent the self-employed from using their insurance premium deduction in the way I’ve outlined above – or if there is, at least I can’t find it, and I’ve spent a lot of time reading the law and regulations looking for it. But IRS has not yet issued the forms or worksheets required for calculation of AGI under the ACA provisions, and in the end the IRS interpretation is what will govern. Whatever IRS puts into its forms will be incorporated into tax software, and used by reputable accountants in their calculations. So those future forms — and not the word of some blogger– is what will govern in the end.
I believe that, as currently written, the law allows the self-employed to chain their deductions in the way that I have outlined above. I also believe that there a significant number of lawyers and tax accountants who are self-employed, and I am sure that some of them will interpret that law as I have and be willing to take the IRS to court if there is a disagreement. But I also believe that this is probably a drafting error in the law – an outcome that simply was not addressed or foreseen when the law was originally written. I’ll explain my reasoning in a future post.
Keep in mind that Congress has the power to change the law at any time, and I don’t think there would be much controversy over a provision to amend the law to require that specified AGI deductions be disregarded in calculating AGI for purposes of determining subsidy eligibility.
The safest choice for self-employed individuals who are unsure of subsidy eligibility is to buy insurance through an exchange, opt to pay the full cost premium cost, with a plan of maximizing tax deductions with the possibility of a substantial tax refund down the line. That way you will not be caught with a huge tax bill in 2015 because your calculations were off the mark or because some astute Congress members push through an amendment in 2014 to specify more add-backs to MAGI than the current law specifies.
Above all. Do not rely on this blog or any other for tax advice!!! It’s possible that the very best investment you can make for your business in 2014 will be to hire a tax professional to help guide you through this maze.