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Tax Treatment of Health & Disability Insurance

Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

In this lesson we will briefly review how the premiums and proceeds of health and disability insurance policies are treated for federal tax purposes by the IRS.

Health and Disability Insurance Tax Treatment

Tom is going over his benefits package at work during open enrollment season and notices he is eligible for health and disability insurance. A coworker told him he should sign up because of the tax benefits. Let's go over with Tom how the tax treatment of the premiums and proceeds of these insurance policies work.

Health Insurance Considerations

Employer health insurance packages offer a number of tax advantages. The IRS generally treats the value of health insurance coverage as exempt from taxes. Insurance premiums are paid by the employee and/or employer for access to health insurance coverage. The premiums that Tom pays for the policy can be paid with pre-tax dollars which have the effect of reducing his taxable income. If Tom's employer pays for a portion of his health insurance premiums, that amount doesn't count as taxable income.

An exception to the tax-free treatment of premiums applies when a worker is an owner in an S Corporation. If Tom were to own two or more percent of the company, the cost of his health insurance benefits would be counted as taxable income by the IRS.

When an insurance policy pays for the costs of treatment, these expenses do not qualify as taxable income. Money placed into a flexible spending account or a health savings account provides a source of funds that can be used to pay for qualifying health care expenses tax-free. Another benefit is that these funds can be used tax-free for the qualifying expenses of Tom's dependent spouse and children.

Long-term care insurance policies are generally treated by the IRS as healthcare coverage. These policies help cover the cost of expenses of extended nursing home or in-home care. Because of this, the proceeds paid from qualifying plans are not taxed.

Disability Insurance Considerations

Disability insurance policies provide financial compensation for injuries and illnesses that prevent someone from continuing to work. Generally, disability policy premiums purchased by an employee are paid with income earned after taxes have been paid. The reason for this is that if the premiums are subject to tax, then the proceeds of the policy are received tax-free. If Tom has the option of paying premiums with before or after tax dollars he should very carefully consider the consequences to his budget if he has to pay the taxes now or later. If Tom's employer were to pay for the policy then any disability benefits Tom receives would be taxed as income.

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