Self Employed Health Insurance Deduction – Alternative Calculation

This post is my continuing effort to translate an IRS regulation  from legalese  into English.  The source document is here:   26 CFR 601.105: Examination of returns and claims for refund, credit, or abatement;

This post won’t make any sense at all unless you read my previous explanation of the Iterative Calculation.

If you have read that post, you know that the problem, mathematically, is that calculation of the correct insurance premium tax credit together with the self-employed health insurance deduction creates a circular reference.  As the CREDIT increases, the amount that might be claimed as a DEDUCTION for payment of premiums is reduced, but when the DEDUCTION is diminished, the MAGI is increased, which in turn reduces the amount of available CREDIT.

If a taxpayer has accepted and advance premium subsidy in excess of the amount of the actual CREDIT to which he is entitled, then the impact of clawback limitations may effectively prevent the need for repeat calculations.

But in the case of a taxpayer who has not taken the advance premium credits — or one who has accepted less money in advance payments than the amount allowed based on family income– an exact calculation when done by hand will require multiple repetitions until an exact figure is reached. The IRS “Iterative Calculation” requires that the taxpayer repeat the calculation until the difference between the new calculation and the previous result is less than $1.  As IRS practice always allows for rounding of figures to the nearest dollars, this procedure will result in the taxpayer receiving the maximum possible credit mathematically.

However, IRS also sets forth an “Alternative Calculation”.  I am not going to go through a step-by-step analysis of the Alternative, because the instructions are the essentially the same as what is printed on a shampoo bottle:  “lather once, rinse, repeat.”

In other words, the Alternative Calculation is almost exactly the same as the iterative calculation, except that the taxpayer stops after step 4 and uses whatever numbers they have at that point.   In the example I gave in my previous post, that resulted in a calculation of a tax credit that was about $5 less than the amount the taxpayer was actually entitled to.

There is one more difference:  if you do the iterations the point where they fall with the $1 range of variation, IRS lets you take the final numbers to determine both deduction and credit.  But if you opt for the Alternative approach, there is a little bit of sleight of hand going on.  You get the 2nd iteration credit, but you have to stay with the deduction determined on the first iteration.   Mathematically you are stuck– that’s the only way that the numbers come out properly when you haven’t gone to the effort to reduce the numbers down to the level of less than $1 variation.

So we might look at the “Iterative” approach as the one designed for a perfectionist or person with OCD.  The “Alternative” approach is the “good enough” approach. I’m assuming that the folks at IRS who came up with formula have run through it enough to figure out that the number that comes up at the “step 4” stage (or 2nd repeat calculation) is always going to be “close enough” if not perfect. I’m also guessing that they have figured that it will pretty much always come out in the IRS’ favor.

IRS gives its own set of examples and they pretty much show similar results.  A pretend family of   4 with an $82,425 household income and $14,000 insurance policy, and $10,500 of advance premium tax payments ends up with a $6,000 tax deduction and $6,740 tax credit, no matter how the calculation is done.

If the same numbers are run with the family paying full cost for insurance — without accepting the advance credits — then the 2nd round “Alternative” calculation yields a $6322 deduction and a $6770 credit.

If the family crunches the numbers until they are near-perfect with the Iterative calculation, the numbers come out differently, but not by a whole lot. The end result after 5 iterations is that the family has a deduction of  $7151 ($828 larger than the amount obtained with the Alternative approach) — and a credit of  $6849 ($79 more than obtained with the Alternative approach).

I think the way the IRS looks at it is this:  The “Alternative” approach yields a ballpark figure that ends up favoring them.  It’s advantageous to IRS if taxpayer  opt to take a smaller credit and smaller  deduction because they don’t want to do a lot of math.  Taxpayers have a right to maximize their credits and deductions, but the IRS is doing itself a favor by providing  a short cut that makes it easier for taxpayers to take a smaller credit than what they are entitled to.

I could be mistaken, but I think the math will always work out that the 2nd iteration — the stopping point in the Alternative calculation, will always yield the lowest deduction and lowest credit possible.  That’s because the taxpayer starts the first iteration with the highest possible deduction (either the total paid for premiums without a credit, or the maximum possible deduction based on premiums paid and clawback limits.) That calculation reduces MAGI the most,  resulting also in the highest possible credit — and reducing the deduction to the lowest possible amount.  When the taxpayer recalculates using the “step 3” deduction, their MAGI will come out higher and their credit will be reduced.

Here’s my takeaway after number crunching:

A taxpayer who qualifies for a a credit but owes  clawback amount, based on advance payments that exceed the clawback limits, should use the Alternative calculation.  In that group the calculation works because the maximum deduction is easily determined.

Others should stick with the Iterative approach. For people who are actually eligible for a credit that is in excess of amounts they have already received,  they will always gain by carrying out the calculations to the last possible iteration. It’s not all that difficult with the help of a spreadsheet to do the calculation.  If we are lucky, it will be built into tax software packages — its something that a computer can be easily programmed to do.

If a taxpayer with self-employment income is fairly confident that the end-of-the-year results will be in an amount that qualifies for a tax credit, that person will come out ahead by taking the maximum advance premium subsidy that can be justified by anticipated income, because of the clawback limits.

But a taxpayer whose income exceeds the 400% federal poverty line after accounting for all deductions will end up having to pay the full difference amount of overpaid credit in taxes.

I created this blog with the self-employed earner on the cusp of eligibility in mind.   I was trying to figure out how best to plan for the future, not knowing exactly how IRS would handle the circular math problem — so my advice to taxpayers was to play it safe, forego the advance credit, reserving the right to claim a credit at the end of the year.

I’ve changed my view:  unless a taxpayer is reasonably certain that they will not qualify for a tax credit, the best course of action for the self-employed is to project income for the coming year as low as as is reasonably possible.  (Very few self-employed earners have a consistent income, so it is not dishonest to be conservative in our projections).   Then the earner should also maximize the amount of advance payment they take– but be aware of and prepared to pay the maximum allowed clawback amount if required.   So the wisest course of action for those “on the cusp” is to accept the subsidies, but bank the difference so the cash is there, if needed, to settle a tax bill with IRS the following year. This approach takes some discipline – but if someone can stick to it then they have a good chance of getting the benefit of extra pre-paid tax credit dollars that don’t need to paid back.

For those who can’t bank the difference…pay whatever you can afford for insurance up front. It may cost you a little bit  more, but you don’t want a tax bill you can’t pay at the end of the year.

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11 thoughts on “Self Employed Health Insurance Deduction – Alternative Calculation

  1. I knew the IRS regulations would be complex but was hoping for something similar to HCTC Form 8885. Your interpretation seems correct and demonstrates the difficult job tax pros will have explaining it to clients.

    I didn’t foresee a difference in subsidy based on taking an advance credit or not, other than the repayment limitation. It now seems that one should minimize estimated income to get the maximum advance credit without triggering Medi-Cal requirement and pocket the excess over the limitation (maybe that will be considered taxable income or deductible from future tax refunds?). That excess could be considerable and easy for many to exceed cap (max for single is only $1250). SE can consider any repayment due just another factor in quarterly estimated taxes.

    Any increase in AGI by amount of the premium credit will also affect other taxes and credits. Higher AGI can reduce or eliminate EITC or Savers Credit among others as well as increase income tax. Low income taxpayers can also receive other benefits base on AGI such as reduced utility bills. It’s possible that claiming a slighty lower PTC could be better than full amount. This will require several other what if iterations before finalizing tax return.

    I use a worksheet for estimating throughout the year but get a preview version of tax software in October to due projections using the preliminary forms and procedures available at that time. This allows a few weeks to make any moves before year end (delaying income or paying expenses) to get a good estimate and eliminate any surprises.

    • The difference in subsidy amount vs advance credit limitation is only due to limitations in total clawback amount for those who continue to qualify for the credit — that is, it can be significant for an individual whose annual income from self-employment might fluctuate between $35,000-$45,000 a year, and even more so for larger households where the 400% FPL mark reaches to higher incomes. But anyone whose income crosses above the 400% Federal Poverty threshold will have to pay 100% of their subsidy back – so I would still think it best for anyone whose income can potentially exceed that limit to either forego the subsidy or else bank difference, so the funds are available come tax time. I agree that in some cases these issues can be resolved via quarterly tax payments.

      I am quite sure that amount of money that are not collected because of clawback limitations are not taxablencome or amounts that could carry forward to future years, as you suggest — that simply isn’t what the law says. I think the clawback limitations are there so that taxpayers don’t end up facing repayment amounts that are wildly disproportionate to their income. Because the exchanges do income verification at the outset, I think in practice these amounts really won’t end up being huge windfalls.

  2. The excess PTC over repayment limit isn’t includable as income or recoverable from tax refund, but don’t bet that won’t happen in the future to prevent people from gaming the system. The excess PTC can be substantial if you are older (higher base cost) and project low income but later file at higher level and will be difficult to prove understating income just to get excess PTC. Marketplace income verification uses prior tax year which isn’t always good measure of the current year. Only wages are reported quarterly on state payroll tax forms during the year, everything else is annual after year end.

    This shows major flaw in the ACA requiring estimated annual and sometimes monthly income. That may be reasonable if nothing changes and your income is stable and consistent during the year, but for many (esp. SE and temp/seasonal workers) it’s just not possible to be very accurate. Many taxpayers don’t know their AGI until they file tax return in following year (as late as 10/15 deadline) and certainly not before open enrollment (11/15/14 to 02/15/15 for calendar 2015).

    Many SE are on cash basis of accounting so their income can also be variable and controllable in ways not possible for employed getting paychecks. At year end SE can decide if and how much to contribute to retirement plan to reduce AGI. That’s a powerful method of reducing taxes and increasing allowable credits especially if you have both an IRA and 401k plans and for those with the cash to invest.

    Anyone near a cutoff point for subsidy or credit needs to consider all possible ways to minimize income. If you use any estimating techniques you can see how even a dollar can change things. An example is Savers Credit that drops from $2000×0.5 to x0.2 for single person if taxable rises $1 from $18000 and drops from 0.1 to nothing at $30001. Even more dramatic is losing entire PTC if single income rises $1 to $45961.

    The PTC or repayment thereof is just another factor in estimating and paying quarterly tax payments to prevent penalties and difficulties paying balance due in April. Another complex calculation to add to the pile we already have to deal with.

  3. Monica, it’s hard to know what changes may be made in the future, but it would require new legislation from Congress to change things, and changes could be prospective only. So for now, the system is what it is.

    I saw (and wrote about) many of these issues with self-employment income early on, but I came to realize that from a practical perspective, these nuances in subsidy calculation are probably dwarfed by the larger problem that IRS faces with self-employed taxpayers, given that many do under-report income or overstate expenses.

    Obviously good planning and awareness is important for all self-employed, but as you pointed out, many do have the ability to defer income into the following year, or to increase business spending to avoid crossing a threshold. So while there is a hypothetical problem of the +$1 over the line resulting in thousands of dollars of lost premium credit — I am thinking that will not be the typical scenario. (There are all sorts of small expenses that I am technically entitled to write off but usually don’t– it’s just not worth it to me to spend time digging through a bag of small-dollar receipts for the sake of a minor tax benefit — but if thousands of dollars were at stake, then of course I would tackle that task.)

  4. Thanks for the post! Keep us updated if you become aware of software/program that does the iterations to the “correct” figures for the SE health deduction/ACA credits.

    • I think that the calculations will be included in the standard tax preparation software programs like TurboTax or H&R Block. In fact, I would be very surprised if they don’t. The math is easy, the trickier part is incorporating the information about poverty levels and making sure that the percentage allowed to calculate credits corresponds to the final AGI figure. But it’s no different from the other functions that tax software already performs.

      I think I could probably figure out how to write a calculator program in Excel that would perform the same calculation– I just think that it would take me several hours and it will be easier for me to simply wait until the preview editions of the tax software are available.

      • I made a modification to my personal tax planning worksheet using the iteration option in Excel that seems to work. It takes several steps which follows the format of the Form 8962. The lookup table of “Applicable Factors” Income as % FPL has almost 170 rows (taken from IRS webinar document). My annual worksheet already had most of the other linked calculations built from years of refinements and tax law changes. The problem is so many taxes, credits and deductions are interwined that the best answer is still hard to determine. If you can control your AGI by using variables such as retirement plan deductions you may have even more what-ifs to run through. The fewer variables you have the easier it may be to approximate the ACA credit and taxable income, but if you are near marginal breaks in AGI it can be tricky. Tax prep programs will certainly have the computations built in, but that means waiting until October to get preview versions that still may not have all the forms and calculations. I can’t wait until January final releases before knowing my situation so I hope my worksheet is reasonably close to enable year end tax planning then decision on contribution to 401k before filing. This is certainly not a welcome additional to tax planning, especially if income can be unpredicable and complicated with multiple sources and types.

      • To my surprise, the calculations are not included in H&R Block software! I get an error message telling me to consult an H&R Block professional, after I’ve spent hours entering the information to the software. Perhaps TurboTax is more comprehensive. I’m self-employed and we received a subsidy for the healthcare premiums, but we have to pay part of the subsidy back.

  5. Pingback: My premium subsidy is dependent on my AGI. But I’m self-employed, so my AGI is dependent on my premium. Help!

  6. Hello! Hope someone can help me with the Premium Tax Credit. I used HR Block Software last year and of course had a terrible time calculating insurance deduction. So my questions is if you use your Premium Tax Credit throughout the year, can you still use what you pay for insurance as a deduction. For example if your insurance premium is $12,000 and you received a $6050 tax credit to pay premium but pay $5950 out of pocket. Is the $5950 your deduction? Thanks for any information or input!

    • Renee, the answer to that question is yes, if you are self-employed, you can deduct the balance of premiums you pay after subsidies; but no, you can’t calculate it using simple subtraction. That is because the self-employed insurance deduction reduces your adjusted gross income, which in turn increases the level of subsidy (premium tax credit) that you are entitled to. But as your tax credit goes up, the amount you can deduct goes down, increasing your adjusted gross income, and thereby reducing the credit. In other words, it is more likely that when the tax software is done, you will end up with both a tax credit and a deduction, but the numbers will be different.

      If your income was higher than anticipated, you can expect to see a smaller tax credit but higher deduction, unless your income is high enough to wipe out the credit altogether. If your income was lower than anticipated, your tax credit would go up and the deduction would be less. Even if your income was about the same as anticipated, the deduction itself reduces income, so is likely to result in a somewhat increased credit.

      So you have go back and forth with the calculation several times in order to find the correct amounts.

      All the major software packages should now be able to handle the calculations for you, though HR Block could not do it during the first year (2014 tax year). Because of the difficulties with HR Block, I stopped using that program and switched to TurboTax, so I can’t personally give you guidance on filling out the forms.

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