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.