But hold up a second! Is this actually the best way to handle these payments? No. As you’ll learn from my s corp blog, the key to saving in an s corp is paying yourself a lower salary provided you’re meeting that “reasonableness” requirement.

With our example of $50,000 being a reasonable salary, you’d be better off paying $45,000 plus the $5,000 premium. That nets you the $50,000 total as required and helps you save more in self-employment taxes. In short, that additional $5,000 you are no longer running as salary is reclassified as a distribution saving you (probably) 15.3% in self-employment taxes, or $765.

Alrighty, so now we understand how boxes 1, 3, and 5 on the W-2 work. We’re not paying self-employment taxes on the amount not reported in boxes 3 and 5, the health insurance costs, but we are paying income taxes since it’s included in box 1.

The good news is that we can recoup the income tax on that amount as well, provided we meet the criteria outlined above. All you need to do is take the self-employed health insurance deduction on your return to recoup those tax withholdings. Remember, this is an adjustment or above-the-line deduction that decreases your adjusted gross income.

In summary, if you qualify for the self-employed health insurance deduction as a sole prop or single member LLC, you save income taxes on the cost of the premiums. If you qualify as an s corp owner, and run things correctly, you save both the income tax and self-employment tax on the cost of the premiums.

HSAs, HRAs, and MERPs

Yes, that’s a lot of acronyms, but hang with me. Each of these health plans fall into the category of Medical Reimbursement Plans (MRPs). Just like the name indicates, MRPs are plans that reimburse or help employees - or small business owners - cover their healthcare costs. Each of these are typically paired with high-deductible health plans (HDHPs).

As you can imagine, HDHPs are typically less costly than traditional health plans. They can be a good option for relatively healthy individuals.

Health Savings Accounts (HSAs)

An HSA is like a little piggy bank. You stash away cash in the HSA to cover future healthcare costs. The best part, you don’t pay taxes on the money before it hits your piggy bank, and the tax person doesn't come knocking when you take the money out either, provided you’re meeting the IRS requirements.

The big requirement is that - if you use the funds - you’re using them only to pay for qualified medical expenses. Most legitimate healthcare costs will qualify. If you’re unsure give it a Google before you go spending the money. Note that many gray area items, like massages, may actually qualify if they have been specifically prescribed by a physician.

To get started, you will want to look for an HSA-eligible high deductible health plan (HDHP).

Once you’re set up, the tax deductions are pretty simple, like the self-employed health insurance deduction, HSA contributions are taken as adjustments on the tax return. This makes things easy for all the non-s corp folks. For s corp owners the tax treatment is the same as standard health insurance costs. Contributions to the HSA are added to your income on your W-2 (box 1 only). You then take the adjustment on your tax return.

Health Savings Account Limitations

Due to the amazing tax benefits, there are limits on how much you can contribute to an HSA. In 2021, individuals may contribute up to $3,600 in one year. If your HSA covers your whole family, the limit is $7,000.

Health Savings Accounts for Retirement

Most of us don’t think of HSAs as an investment vehicle. Instead, we view them through the lens of insurance and medical expenses. However, the tax benefits make HSAs one of the most powerful tools to save for retirement.

For starters, consider how much more we generally expect to pay for healthcare in our older years.

There’s no obligation to spend your HSA funds at any point. The money in the account can grow and grow with compound interest much like a 401(k) or IRA, but the HSA actually has even better tax treatment.

For this reason, the best way to use your HSA might be to not use it at all (other than funding it of course). Instead, you can let it grow and grow while continuing - if you can afford to do so - paying out-of-pocket for your healthcare costs.

For more information on retirement savings and taxes, check out this blog post.

Health Reimbursement Arrangements (HRAs)

These are employer funded plans that reimburse employees for out-of-pocket healthcare costs. I was prepared to write a whole damn section on HRAs until it dawned on me that these are only really useful to c corps, so I’ll spare you further explanation.

Medical Expense Reimbursement Plans (MERPs)

A MERP is a type of HRA. They allow business owners to take a deduction for reimbursements made to employees. That deduction then saves the business both income tax and self-employment tax. But this is a more complicated and advanced strategy if you don’t have standard employees.

You must have an employee, other than yourself, to qualify for a MERP. The only exception to this rule is when you have a c corp, which is basically none of us. Interestly, you can hire your spouse as an employee to qualify unless you have an s corp. However, there is a workaround for these s corp owners. I recommend consulting a well qualified tax professional to get help setting that up. If you have a high income earning business, it may be well worth your trouble.

When to Start Using These Benefits

Now. That’s the answer. 

With many tax strategies, we talk about when it makes sense to pull the trigger, like with forming an s corp. This topic is different. We all need health insurance. Regardless of whether your business brings in 7 figures or if you’re scratching the surface of 5 figures, health insurance isn’t a bad idea.

If you don’t have employer sponsored insurance, and don’t qualify for government subsidized insurance, go out and see what you can afford. Then, get those tax deductions. 

Wrap Up

Part of me feels as if I did a great job taking pages and pages of notes I had on this topic and synthesizing it down to only what’s useful for small business owners. I’m patting myself on the back as you read this. The other part of me feels like I’m just scratching the surface. How do you feel? What lingering questions do you have? Are there any healthcare deductions, benefits, or plans you expected to hear about? Post in my Facebook Group and let me know. I’ll do my best to answer, and you may help me supplement this post in the future.

Ultimately, you must weigh and balance tax considerations with your healthcare needs. I’d caution you to primarily focus on your healthcare needs. Don’t screw yourself in the long run to save $1,000 in taxes now. Instead, determine what your coverage options are. Do the research. Choose the best path forward. Then, capitalize on the tax savings available to you with that chosen plan.