Tax Breaks on Medical Costs

Updated on January 4, 2008.

THERE'S MORE TO HEALTH-CARE tax breaks than the itemized deduction.

The most common way people treat their health costs on their tax forms is by claiming an itemized deduction, on Schedule A of the 1040, for out-of-pocket medical expenses (including health and dental insurance premiums) to the extent they exceed 7.5% of adjusted gross income (AGI).

But, clearly, this isn't a very good deal. For example, say your AGI is $80,000 and you have $10,000 of health costs. Your Schedule A itemized deduction is limited to a relatively paltry $4,000 ($10,000 minus $6,000, which is 7.5% of your $80,000 AGI). Even worse, if you're in the dreaded alternative minimum tax mode, you can only deduct medical expenses to the extent they exceed 10% of AGI. If your expenses only add up to $5,000, you're completely out of luck because they fall beneath the 7.5% of AGI threshold. This stinks!

But all is not lost. There are some strategies you can use to maximize the tax breaks of the cost of care.

Concentrate Medical Expenditures in Alternating Years
If you have some flexibility about when your medical expenses are incurred, you may be able to concentrate them in alternating years. That way, you can at least claim an itemized deduction every other year instead of never.

For example, say your annual AGI is $60,000. In 2008, you pay $7,000 of medical expenses because you have elective surgery, buy new glasses and contact lenses, and have some expensive dental work done. Next year you pay only $2,000. In 2008, you can claim a Schedule A itemized deduction of $2,500 ($7,000 minus $4,500, which is 7.5% of your $60,000 AGI). Next year, you won't be able to claim any deduction. But if you simply spread the two-year total of $9,000 worth of medical costs evenly over 2008 and 2009, you will be out of luck in both years.

Don't Forget Long-Term-Care Insurance Premiums
A qualified long-term-care policy is considered health insurance under the federal income tax rules. When you personally buy a qualified policy, the premiums you pay are treated as medical expenses for itemized-deduction purposes on Schedule A. However, there are limits. You can only treat the age-based amounts listed below as medical costs (these numbers are adjusted annually for inflation).

For example, say you and your spouse are both in the 51 to 60 category. You pay an annual premium of $5,000 for a qualifying long-term-care policy that covers you both. For 2008, you can include $2,300 (two times $1,150, since the policy covers both spouses) in the medical-expense pot for purposes of clearing the 7.5% of AGI threshold.

Now say you're 63 years old and pay an annual premium of $5,000 for a qualifying long-term-care policy that covers only you. For 2008, you can include $3,080 in the medical expense pot for purposes of clearing the 7.5% threshold.

Deduct Expenses Paid for Parent or Grandparent
Do you pay medical expenses for a dependent parent? If so, you can add those expenses to your own for itemized-deduction purposes. To be your dependent, however, over half of your parent's support for the year must be paid by you. If you pass the support test, you can include medical expenses paid for your parent even if you can't actually claim your parent as a dependent on Form 1040. (You can't claim a parent as a dependent if he or she files jointly or has over $3,500 of gross income for 2008). While you must still clear the 7.5% of AGI hurdle to claim an itemized deduction on Schedule A, including your parent's expenses in the pot may help.

The exact same considerations apply to medical expenses that you pay for a dependent grandparent.

Remember: If you pay qualifying long-term-care insurance premiums for a dependent parent or grandparent, you can include the age-based premium amounts from the table shown above.

Finally, if you pay for a dependent parent or grandparent to enter or stay in a continuing-care retirement community, you may be entitled to an unexpectedly juicy medical expense write-off for part of the cost.

What if you pay medical expenses for a parent or grandparent but don't supply over half of his support for the year? In this case, you cannot combine the parent's or grandparent's medical expenses with your own for itemized-deduction purposes.

Take Advantage of a Health-Care Flexible Spending Account
So far, I've focused on some ways to work around the dreaded 7.5% of AGI threshold. At best, however, these are only damage-control procedures. When possible, it's far better to simply avoid the darned threshold in the first place. Often, the easiest way to do this is to take advantage of your employer's health-care flexible spending account.

Under an employer-sponsored FSA plan, you're allowed to contribute part of your salary to fund your personal FSA. For tax purposes, these so-called salary-reduction contributions are subtracted from your pay — which reduces your federal income tax, Social Security tax, and Medicare tax bills (and maybe your state income tax bill, too). You then submit evidence that you've incurred qualified medical expenses and receive tax-free FSA reimbursement checks to cover them. In effect, the FSA allows you to pay for those expenses with pretax dollars, which is a whole lot better than paying income and employment taxes on your entire salary and then hoping for a little relief under the 7.5% of AGI rule.

Open Up a Health Savings Account
If you pay for your own medical-insurance premiums, you might consider acquiring a qualifying high-deductible health policy and then making annual tax-deductible contributions to a health savings account. You can then take tax-free HSA withdrawals to cover your uninsured medical expenses. Once again, this drill allows you to pay medical expenses with pretax dollars while neatly sidestepping the 7.5% of AGI threshold. Better yet, you may be able to leave your HSA largely or completely untouched, invest the account balance, and build up a substantial tax-favored fund to cover medical costs in the future.

Of course, the HSA idea doesn't work if you would have difficulty making annual HSA contributions due to uncertain cash flow. Also, if you or members of your family are in poor health, having high-deductible health coverage is probably not the right move for you.

If You're Self-Employed...
Self-employed folks who pay their own medical and dental insurance premiums are generally allowed to deduct these costs "above the line" on page 1 of Form 1040. This rule is very helpful, because you need not itemize to benefit from an above-the-line deduction. Also, you can include the age-based amounts listed above for qualified long-term-care insurance premiums in your above-the-line write-off. Unfortunately, that's the end of the good news. In general, your only recourse for uninsured medical expenses is claiming a Schedule A itemized deduction when those costs exceed 7.5% of your AGI.