6.1 Medical expenses and health savings accounts

Medical expenses and health savings accounts are crucial components of itemized deductions. They offer potential tax savings for individuals with significant healthcare costs, but come with specific rules and limitations. Understanding these deductions can help taxpayers maximize their benefits and reduce their overall tax liability.

The IRS allows deductions for qualifying medical expenses exceeding 7.5% of adjusted gross income. Health Savings Accounts (HSAs) provide additional tax advantages, allowing tax-free contributions, growth, and withdrawals for medical expenses. Knowing what qualifies as a medical expense and how to leverage HSAs can significantly impact your tax strategy.

Medical Expense Deductibility

Deduction Basics and Eligibility

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• Itemize medical expenses on Schedule A of Form 1040 as deductions
• Deduct only unreimbursed medical expenses exceeding specific AGI percentage
• Expenses must primarily prevent or alleviate physical or mental health conditions
• Deductible expenses include payments for diagnosis, treatment, or disease prevention
• Exclude cosmetic procedures unless addressing congenital abnormalities, injuries, or disfiguring diseases
• Include medical expenses for spouse and dependents meeting criteria
• Deduct based on payment date, not service date or condition onset

Qualifying Expenses and Limitations

• Cover costs for treatments affecting body structure or function
• Exclude general health and wellness products (multivitamins)
• Include prescription medications and insulin as qualified expenses
• Allow deductions for medical equipment and supplies (wheelchairs, crutches)
• Limit deductions for capital expenses (elevators, swimming pools) to the extent they exceed home value increase
• Exclude most insurance premiums, with exceptions (long-term care, COBRA)
• Refer to IRS Publication 502 for comprehensive list of qualified medical expenses

AGI Threshold for Medical Expense Deductions

Calculation and Application

• Apply current 7.5% AGI threshold to aggregate qualifying medical expenses
• Calculate deductible amount: Total qualifying expenses - (7.5% x AGI)
• Claim positive result as itemized deduction on Schedule A
• Understand threshold creates "floor" limiting deductions for lower-income taxpayers
• Compare potential medical expense deduction with standard deduction for greater tax benefit
• Recognize threshold percentage subject to periodic changes (previously 10%, reduced to 7.5%)

Impact on Tax Planning

• Consider bunching medical expenses in single tax year to exceed threshold
• Evaluate timing of elective procedures to maximize deduction potential
• Explore FSA or HSA options to pay medical expenses with pre-tax dollars
• Maintain detailed records of all medical expenses throughout the year
• Review potential deductions with tax professional to ensure compliance and maximize benefits

Tax Treatment of HSAs

Contributions and Limits

• Contribute to HSAs when covered by high-deductible health plans (HDHPs)
• Deduct contributions from AGI, benefiting even non-itemizing taxpayers
• Adhere to annual contribution limits (2023: $3,850 individual,$7,750 family)
• Allow catch-up contributions ($1,000) for individuals age 55 and older
• Exclude employer HSA contributions from employee's taxable income
• Contribute until tax filing deadline for previous year (typically April 15)

Distributions and Tax Advantages

• Grow HSA funds tax-free within account
• Withdraw tax-free for qualified medical expenses
• Pay income tax and 20% penalty on non-qualified distributions before age 65
• Remove 20% penalty (but not income tax) for non-qualified distributions after age 65
• Utilize "triple tax advantage": tax-deductible contributions, tax-free growth, tax-free qualified withdrawals
• Carry over unused HSA funds indefinitely, unlike "use-it-or-lose-it" FSAs

Qualified vs Non-Qualified Medical Expenses

Qualified Medical Expenses

• Align with medical and dental expenses deductible on Schedule A
• Include costs for diagnosis, treatment, or prevention of medical conditions
• Cover prescription medications and insulin without prescription
• Allow medical equipment and supplies prescribed for specific conditions (hearing aids, blood sugar test kits)
• Permit certain insurance premiums (long-term care, COBRA, health coverage while receiving unemployment)
• Include travel expenses primarily for and essential to medical care (mileage, parking fees)
• Approve medically necessary home modifications (wheelchair ramps, grab bars)

Non-Qualified Expenses and Exceptions

• Exclude general health products (toothpaste, dietary supplements) unless prescribed
• Disallow cosmetic procedures (teeth whitening) except when medically necessary
• Prohibit expenses for general well-being (gym memberships, nutritional supplements)
• Reject childcare costs, unless primarily for medical care of disabled dependent
• Exclude funeral or burial expenses from medical expense category
• Deny reimbursement for expenses covered by insurance or paid by other sources
• Require documentation and potential professional guidance for ambiguous expenses