[This is a guest post from Bogleheads investment forum participant Bob’s not my name as a follow-up to his previous post How Much Will the New Health Care Taxes Affect High Earners?]
There hasn’t been much discussion of how screwed middle class families with significant medical expenses are going to be by a couple of seemingly minor changes introduced by the Affordable Care Act (ACA). I don’t even recall the screwation of the middle class being discussed as a major goal of the ACA — but surely it must have been, right?
Medical deductions threshold increased to 10% of Adjusted Gross Income
Since the 10% threshold already applies in the Alternative Minimum Tax, this would apparently have no impact on the high earning taxpayers targeted by the much discussed new Medicare taxes on families with income over $250,000. This is aimed squarely at the working middle class (seniors get a four-year holiday on this new rule).
A family with $120,000 in Adjusted Gross Income (AGI), with $15,000 of unreimbursed medical expenses, and living in a taxy state that follows Federal itemized deductions would pay an additional $1,100 or so in income taxes, which is 0.9% of their AGI.
As a percentage of their AGI, high earners will never see an ACA Medicare tax that high (because the new 0.9% Medicare tax applies only to their income above $250,000, not all of their income). The idle rich (that is, those with no earned income but lots of investment income) won’t see an ACA investment tax that high unless they have more than about $8 million of investments in taxable accounts.
Health Flexible Spending Account contributions limited to $2,500/year
This is an important limitation for families with access to only one Flexible Spending Account (FSA) and significant foreseeable medical expenses, such as a family with teenagers who will need glasses and contacts, wisdom teeth removal, and braces.
Such families may also be subject to very high effective marginal rates due to AGI-based credit phaseouts, such as the education credits and the child tax credit, so the loss of the FSA as a means to shelter income from these very high federal marginal rates, state taxes, and payroll taxes is a substantial setback. The damage to a family in the Lifetime Learning Credit phaseout and living in a taxy state might be on the order of $1,500, or possibly 1.25% of AGI for a family with $120,000 AGI..
Combined, these two ACA changes could increase a middle class family’s taxes by a few thousand dollars a year (but only if they have significant medical expenses — healthy families would be unaffected).
I see four mitigation tactics. The first three are obvious:
- Max out your FSA each year, especially if your plan has a grace period that overlaps the following year, and especially if the IRS modifies the use-it-or-lose-it rule, which is under consideration.
- Max out your traditional 401k to reduce your AGI; this gets you under phaseouts and also reduces the medical deduction threshold.
- Bunch medical expenses into one calendar year if you can.
The fourth is less obvious: contribute to a deductible traditional IRA instead of a Roth IRA. Like a traditional 401k, this reduces your AGI and can get you under credit phaseouts. In addition, if you have a major medical emergency, a traditional IRA can be tapped penalty-free to pay for deductible medical expenses. This exception would allow a penalty-free and tax-free withdrawal since expenses over 10% of AGI are deductible. This doesn’t solve the problem that expenses under 10% of AGI aren’t deductible, but it does mitigate your total out-of-pocket expense to cover an unanticipated major medical expense.
For example, take a family with $120,000 AGI and a $30,000 medical bill. They have one FSA that, thanks to the reduced limit, covers only $2,500 of the cost. The next $12,000, thanks to the raised floor, is not deductible, so they have to pay $12,000 out of pocket with no tax relief. That leaves $15,500. They withdraw $15,500 from their IRA, pay almost no penalty and almost no tax.
Why almost? Because they are in the child tax credit phaseout, which is based on AGI rather than taxable income, and effectively taxes their IRA withdrawal at 5%. States that tax IRA withdrawals and don’t follow Federal itemized deductions would also tax the IRA withdrawal. Finally, there’s a weird looping effect here because a Traditional IRA withdrawal will increase your AGI, which increases the deduction threshold.
Many people think they’re not eligible for deductible Traditional IRA contributions when they are. Also see Harry’s previous post The Forgotten Deductible IRA.
The most overlooked case is a couple married filing jointly with about $200,000 of gross income and one spouse not covered by an employer sponsored retirement plan like a 401k. If the covered spouse is over 50, contributes $22,500 to a 401k, has $4,000 of pre-tax insurance premiums, and contributes $2,500 to a FSA, the couple’s AGI is $171,000 and the uncovered spouse is eligible for a $5,000 ($6,000 if over 50) deductible contribution to a spousal Traditional IRA (eligibility starts phasing out at AGI $173,000 in 2012).
The deduction is very nice because this couple is probably in the AMT and may be in a taxy state, so their marginal rate might be over 40%.
[Updated on Nov. 7, 2012 with minor edits.]