3.3 Reimbursements and Other Tax-Free Payments From Employer Health and Accident Plans
Several types of payments from a health or accident plan are tax free to you even if your employer paid the entire cost of your coverage:
Payments that are not within the above tax-free categories, such as disability benefits, are not taxable to you if you paid all of the premiums with after-tax contributions. If your contributions were made on a pre-tax basis, benefits received from the plan are taxable. For example, disability benefits are taxable if you paid premiums paid under a cafeteria plan (3.14) with pre-tax contributions that were excluded from your income. If your employer paid all the premiums and you were not taxed on your employer’s payment, any benefits you receive from the plan are fully taxable. If both you (with after-tax contributions) and your employer contributed to the plan, only the amount received that is attributable to your employer’s payments is taxable.
Tax-Free Reimbursements for Medical Expenses
Reimbursements of medical expenses (17.2) that you paid for yourself, your spouse, or any dependents and your children under age 27 are tax free, provided you incurred the expenses after the plan was established. Payment does not have to come directly to you to be tax free; it may go directly to your medical care providers.
Tax-free reimbursements may be from a health-care flexible spending arrangement (FSA) (3.16). Reimbursements made under a qualifying health reimbursement arrangement (HRA) also qualify for tax-free treatment; see below.
Tax-free treatment applies only for reimbursed expenses, not amounts you would have received anyway, such as sick leave that is not dependent on actual medical expenses. If your employer reimburses you for premiums you paid, the reimbursement is tax free so long as your payment was from after-tax funds. If you paid premiums with pre-tax salary reductions, a “reimbursement” from the employer will be taxable to you because the salary reductions are treated as your employer’s payment, not yours.
Reimbursements for cosmetic surgery do not qualify for tax-free treatment, unless the surgery is for disfigurement related to congenital deformity, disease, or accidental injury.
Caution
Reimbursements for your dependents’ medical expenses are tax free. This exclusion applies not only to reimbursed expenses of persons claimed as dependents (21.1) on your return, but also to expenses of qualifying children or relatives who cannot be claimed as your dependents because: (1) they are claimed by the other parent under the special rules for divorced/separated parents (21.7), (2) their gross income exceeds the limit for qualifying relatives ($3,800 for 2012), (3) they file a joint return with their spouse, or (4) you are the dependent of another taxpayer and thus are barred from claiming any dependents on your return.
A qualifying dependent does not include a live-in mate where the relationship violates local law.
If the reimbursement is for medical expenses you deducted in a previous year, the reimbursement may be taxable. See 17.4 for the rules on reimbursements of deducted medical expenses.
If you receive payments from more than one policy and the total exceeds your actual medical expenses, the excess is taxable if your employer paid the entire premium; see the Examples in 17.4.
Health Reimbursement Arrangements (HRAs).
Employers can set up health reimbursement arrangements (HRAs) to reimburse out-of-pocket medical expenses of employees, their spouses, children under age 27 and their dependents. Former employees including retired employees, and spouses and dependents of deceased employees can be covered. Self-employed individuals are not eligible. An HRA must be funded solely by employer contributions and not by salary reductions or after-tax contributions from employees.
Employees are not taxed on HRA reimbursements for medical expenses that may be claimed as itemized deductions (17.2), including premiums. Over-the-counter medicines or drugs other than insulin do not qualify for tax-free reimbursement from an HRA unless they are prescribed by a physician. For contributions and reimbursements (3.1) to be tax free, employees must not receive cash or any benefit (taxable or nontaxable) from an HRA other than reimbursement for medical expenses. If the reimbursement limit is not fully used up by the end of a coverage year, the unused limit can be carried forward to a subsequent year. Nondiscrimination rules apply to self-insured HRAs.
Self-employed health plan that includes spouse.
If a self-employed person hires his or her spouse and provides family coverage under a health plan purchased in the name of the business, the employee-spouse may be reimbursed tax-free for medical expenses incurred by both spouses and their dependent children.
Executives taxed in discriminatory self-insured medical reimbursement plans.
Although reimbursements from an employer plan for medical expenses of an employee and his or her spouse and dependents are generally tax free, this exclusion does not apply to certain highly compensated employees and stockholders if the plan is self-insured and it discriminates on their behalf. A plan is self-insured if reimbursement is not provided by an unrelated insurance company. If coverage is provided by an unrelated insurer, these discrimination rules do not apply. If a self-insured plan is deemed discriminatory, rank-and-file employees are not affected; only highly compensated employees are subject to tax.
Highly compensated participants subject to these rules include employees owning more than 10% of the employer’s stock, the highest paid 25% of all employees (other than employees who do not have to be covered under the law), and the five highest paid officers.
If highly compensated employees are entitled to reimbursement for expenses not available to other plan participants, any such reimbursements are taxable to them. For example, if only the five highest paid officers are entitled to dental benefits, any dental reimbursements they receive are taxable. However, routine physical exams may be provided to highly compensated employees (but not their dependents) on a discriminatory basis. This exception does not apply to testing for, or treatment of, a specific complaint.
If highly compensated participants are entitled to a higher reimbursement limit than other participants, any excess reimbursement over the lower limit is taxable to the highly compensated participant. For example, if highly compensated employees are entitled to reimbursements up to $5,000 while all others have a $1,000 limit, a highly compensated employee who receives a $4,000 reimbursement must report $3,000 ($4,000 received minus the $1,000 lower limit) as income.
A separate nondiscrimination test applies to plan eligibility. The eligibility test requires that the plan benefit: (1) 70% or more of all employees or (2) 80% or more of employees eligible to participate, provided that at least 70% of all employees are eligible. A plan not meeting either test is considered discriminatory unless proven otherwise. In applying these tests, employees may be excluded if they have less than three years of service, are under age 25, do part-time or seasonal work, or are covered by a union collective bargaining agreement. A fraction of the benefits received by a highly compensated individual from a nonqualifying plan is taxable. The fraction equals the total reimbursements to highly compensated participants divided by total plan reimbursements; benefits available only to highly compensated employees are disregarded. For example, assume that a plan failing the eligibility tests pays total reimbursements of $50,000, of which $30,000 is to highly compensated participants. A highly compensated executive who is reimbursed $4,500 for medical expenses must include $2,700 in income:
Taxable reimbursements are reported in the year during which the applicable plan year ends. For example, in early 2013 you are reimbursed for a 2012 expense from a calendar-year plan. If under plan provisions the expenses are allocated to the 2012 plan year, the taxable amount should be reported as 2012 income. If the plan does not specify the plan year to which the reimbursement relates, the reimbursement is attributed to the plan year in which payment is made.
Tax-Free Payments for Permanent Physical Injuries
Payments from an employer plan are tax free if they are for the permanent loss of part of the body, permanent loss of use of part of the body, or for permanent disfigurement of yourself, your spouse, your children under age 27, or your dependent. An appeals court held that severe hypertension does not involve loss of a bodily part or function and thus does not qualify for the exclusion.
To be tax free, the payments must be based on the kind of injury and have no relation to the length of time you are out of work or prior years of service. If the employer’s plan does not specifically allocate benefits according to the nature of the injury, the benefits are taxable even if an employee is in fact permanently disabled.
Filing Tip
Disability payments from profit-sharing plan.
The Tax Court has held that a profit-sharing plan may provide benefits that qualify for the exclusion for permanent disfigurement or permanent loss of bodily function. The plan must clearly state that its purpose is to provide qualifying tax-free benefits, and a specific payment schedule must be provided for different types of injuries. Without such provisions, payments from the plan are treated as taxable retirement distributions.
HSA or Archer MSA Payments
Tax-free distributions from a health savings account (HSA).
Distributions from an HSA (3.2) are tax free if used to pay qualified medical expenses for you, your spouse, or your dependents. Qualified medical expenses are unreimbursed costs eligible for the itemized deduction (17.2) on Schedule A of Form 1040. Over-the-counter medicines other than insulin that do not require a prescription qualify for HSA purposes if they are actually prescribed by a physician. Medical expenses are “qualified” only if incurred after the HSA has been established. A distribution is taxable to the extent it is not used to pay qualified medical expenses. A taxable distribution is also subject to a 20% penalty unless you are disabled or are age 65 or older. Distributions will be reported to you on Form 1099-SA and you must report them on Form 8889, which you attach to Form 1040. On Form 8889, you determine if any part of the distribution is taxable and, if it is, that amount must be included as “Other income” on Line 21 of Form 1040. The 20% penalty from Form 8889, if any, is entered on Form 1040, Line 60 (total tax). On the dotted lines next to Lines 21 and 60, enter “HSA” and the amount on the dotted line.
A non-spouse beneficiary who inherits an HSA after the death of the account owner generally must include in income the fair market value of the assets as of the date of death. However, the beneficiary is not subject to the 20% penalty for taxable distributions. If the beneficiary is the account owner’s spouse, he or she becomes the owner of the HSA and will be taxed only on distributions that are not used for qualified medical expenses.
Tax-free distributions from Archer MSA.
If you work for a small-business employer and have a qualifying Archer MSA (3.2), earnings accumulate in the account tax free. Withdrawals are tax free if used to pay deductible medical costs for you, your spouse, or dependents. Withdrawals used for a non-qualifying purpose are taxable and a taxable distribution before age 65 or becoming disabled is also subject to a 20% penalty. See 12.12 for further details.