Look To Retirement, Disability Plan Taxation For Clarity In Taxing Health Benefits

(Today’s post comes from Ross D. Spencer, general manager and senior writer for Wolters Kluwer Law And Business.)

A June 23, 2009, New York Times column by David Brooks advocates “ending the tax exemption on employer-provided health benefits….” Unfortunately, the term “tax exemption” is not easily understood, and many of its possible definitions are taken for granted and not fully recognized by the general public.

First, there is the tax deduction that employers take for their cost of providing health care coverage. This is considered to be part of “the cost of doing business.” This could be capped. Or, it could be eliminated altogether, which would cause many employers to cease providing employer-paid health care coverage to their general population. Executives will continue to receive their special health care perks, though, because companies will be willing to pay for that coverage even if it is not deductible.

Second, there is the tax exclusion that employees receive for making premium payments through a Sec. 125 premium-only plan.

Third, there is the tax exemption that employees enjoy for benefits actually paid from a health care plan. Think of the cost to the employee if a $50,000 hospital bill paid by the “employer-provided” health care plan were taxable to the employee. Eliminating that exemption would be political suicide.

Looking to existing tax policies as they relate to retirement plans and to disability plans might offer some insight to the consequences of “ending the tax exemption on employer-provided health benefits.” The tax provisions under retirement plans simply postpone the payment of taxes. Monies that are contributed on a “tax-deferred” basis, such as to a Sec. 401(k) plan or a defined benefit plan, are taxable when paid out as benefits. The only issue with retirement plans is when the tax is paid, when the money goes into the plan or when the money comes out of the plan. In health care plans, no tax is payable either going into the plan or coming out of the plan. So, “ending the tax exemption” also would level the playing field between retirement plans and health care plans.

Following the retirement plan model, though, creates the nightmare of paying huge tax bills when the benefits are paid, such as the $50,000 hospital bill.

Perhaps a better model is the tax application of disability plans. If the employer pays the long term disability premium with tax deductible dollars, then the benefits paid out are taxable to the employee. But, if the employee pays the premium with after-tax dollars, then the benefits paid out are received tax free. So, when designing disability plans, there are two choices involving taxes: employer-paid coverage that would create benefits taxable to the employee OR employee-paid coverage that would create benefits not taxable to the employee.

In both the retirement plan tax model and the employer-paid disability model, the benefit that is taxed is fairly low and would generally be known at the time of “purchase.”

However, if health care were treated in the same way, potentially high benefit payouts would not be known before the benefit is actually collected. Using either the retirement plan model or the employer-paid disability model would result in being taxed on that $50,000 hospital bill—clearly not a viable option. Using the employee-paid disability model – in which the average $13,000 family coverage cost would be taxable (but not the benefits) seems better. Paying taxes on the entire $13,000 might be unacceptable, but that is where you would have allowances for low income, offsetting credits, caps, etc.

Perhaps the group term life model could be used, and only the value of the coverage that exceeds a certain amount, such as $10,000 a year, would be taxed, while preserving the tax-free nature of the entire benefit that is paid out. What the employer decides to kick in (and deduct as an ongoing business expense) would be up to employers and Congress.