Goofy Tax Treatment of Healthcare Spending

Arguments along the line of “The IRS shouldn't be involved in health care” seem like a sensible reason to be uneasy about the ACA. That is, until you realize that the tax code is already very involved in the business of health care, with loads of loopholes, clauses, interjections, and exemptions with regard to health care spending. And, surprise! They don't actually make a lot of sense. (That's not the IRS's fault, of course. They just do what they're told by the people passing tax legislation.)

The IRS carefully explains the various ways in which you might be eligible for tax breaks based on your medical spending in Publication 502, a scintillating read. I will neither try to catalogue nor criticize all of these methods here, because that would take forever and wouldn't be very rewarding. But I will point out some of the more egregious corner cases which the ACA hasn't done anything about.

(The tl;dr version of everything I'm about to say is this: If the feds truly think that spending on healthcare should be done with pre-tax dollars, then just rule that all spending on healthcare is done with pre-tax dollars and be done with it.)

Flexible Spending Arrangements (FSAs): Truly, a product designed by actuaries. In a nutshell, FSAs allow employees to set aside pre-tax dollars which can then be spent on a variety of healthcare products and services, as well as a wide swath of child care. But you have to designate the amount you want to set aside before the year begins, you can only change it under limited circumstances, and if you don't use up all the money within about 15 months, you lose it. (Of course, there are also fun ways employees can game the system, because you can spend your FSA allocation on January 1, then quit your job before you actually endure the payroll deductions to fund the FSA account, and there's nothing anybody can do about it.)

The ACA capped annual FSA allocations at $2,500 for some reason, and eliminated coverage for many (but not all) over-the-counter medications and products. (So you can't stock up on ibuprofen pre-tax anymore, but you can still buy saline solution pre-tax.)

Incidentally, the self-employed cannot have FSAs because... well, I don't know why, we just can't. (This guy speculates that it's because we don't have salaries, but that fact doesn't make us ineligible to establish and fund 401(k)s, so I am pretty sure the answer really is “You just can't. Nyah!”)

Health Savings Accounts (HSAs) and Health Reimbursement Accounts (HRAs): These are the rather more sensible cousin of the FSA. Individuals can set aside some pre-tax money ($3,300 in 2014) and park it in a variety of interest-bearing or investment accounts. That money can then be spent at any time in the present or future on health care expenditures. That means you can pay for your healthcare pre-tax today (which, depending on your marginal state and federal tax rates could mean an effective "discount" of 20% or more, just like an FSA). But the ability to let the funds ride indefinitely also makes it a useful pseudo-retirement vehicle for people already maxing out other types of investment accounts. The first problem with this strategy is that HSA/HRA accounts either have terrible interest rates, horrendous fees, or both.

The other problem is that people are only allowed to fund these accounts if they have “qualified high-deductible” (HDHP) insurance plans, which generally means that they cover no services (except the relatively limited range of mandatory preventative care and other zero-copay/coinsurance items) until the deductible is completely satisfied. It is not at all clear to me why funding and maintaining such an account is incompatible with having more generous copay/coinsurance protection than the HDHP model.

The ACA imposed the same sorts of limits on HSA/HRA spending as were made to FSA spending (no more pre-tax Tums). There was a lot of weird handwringing going on that HSA/HDHP plans would be targeted for elimination under the ACA, but I've seen no sign of that. The 2014 ACA policy lists are full of HSA-eligible Bronze plans.

Medical Expenses Above 7.5 Percent of Adjusted Gross Income: Now we're just getting silly. People can take Schedule A deductions for medical and dental expenses, but only if they spend kind of a lot, and even then they can only deduct the amount they spent above and beyond 7.5% of AGI.

Individual Health Insurance Premiums are Deductible... Maybe: As a self-employed individual, I get to take my premium costs off of my AGI (meaning I still paid out 13.3% in Social Security and Medicare on it in 2012, but didn't pay state or federal tax), which isn't a bad deal. The “conventionally” employed get similar advantages when paying for typical employer-sponsored health insurance. Certain types of unemployed individuals can take a partial credit (the Health Coverage Tax Credit), and everybody can count premiums towards the 7.5%-of-AGI calculation in an absolute pinch. Why do only some people get to pay for health insurance pretax? Totally unclear.

So, to recap, we like tax forgiveness if some or all of these are true:

• You spend tons of money on healthcare--but we'll only give you a break on the amount above one ton,
• You're willing to take on more risk, be it the risk that you won't spend all the money in one year (FSA) or the risk that comes with high deductibles and no copay protection (HSA/HRA)--but this privilege only extends to a few thousand dollars per year,
• You have a job, preferably one from a “proper employer” and not a one-man band.

Governing by exception is wasteful and confusing. If it is a social good to let people pay for medically necessary healthcare services on a pre-tax basis, then just let everybody do all of their healthcare spending on a pre-tax basis. If it's not a good idea, then by all means, let's stop doing it. Building more corner cases into the system just further obscures the true costs of care and makes the whole mess more difficult to fix.