A pretax health insurance plan allows you to pay your premiums with before-tax money; your contributions are taken out of your paychecks before taxes are calculated. This results in a reduction of your taxable wages.
Premiums paid toward a Section 125 health plan are excluded from federal income tax, Social Security tax and Medicare tax. For example, you earn $1,300 biweekly and pay $100 total toward your pretax family health plan. You would subtract $100 from $1,300 to get $1,200, which would be subject to taxation.
When you pay your medical premiums with pretax money, you get a tax break because your payment is deducted before taxes are withheld from your paycheck. When you pay with after-tax money, you don’t get a tax break, because your premiums are deducted after taxes are withheld.
To pay your medical premiums with pretax money, you must be enrolled in your employer-sponsored health insurance plan. To offer its employees pretax health insurance, your employer must establish a plan that meets the requirements of Section 125 of the Internal Revenue Code.
If you do not want to participate in your employer’s pretax plan, you may elect to have your medical premiums deducted on an after-tax basis.
Pretax medical premiums are excluded from federal income tax, Social Security tax, Medicare tax and usually state and local income tax. Check with your state revenue agency for clarification on whether Section 125 premiums are excluded from state and local income tax, as the state may have specific conditions.
With a pretax plan, your employer deducts your premiums from your gross wages before calculating taxes. This process reduces your taxable income and results in more take-home pay than if you paid with after-tax money. After-tax premiums do not reduce your taxable income.
If you pay your medical premiums with after-tax money, you may deduct your premiums as a medical expense on Schedule A when you file your tax return with the IRS. Before you can get this tax benefit, your total medical premiums must be more than 7.5 percent of your income. If you paid your premiums with pretax money, you do not qualify for this tax credit since you already received a tax break when your employer deducted the premiums from your paycheck. The pretax option allows you to receive the full tax benefit because all of your premiums are tax free.
Premium Conversion FAQ
Under IRS rules, you may reduce coverage (cancel, or change from Self and Family to Self Only) only during an Open Season or at the time of a qualifying life event.
Paying your premiums with pre-tax money reduces your earnings reported to the Social Security Administration. When you begin to collect Social Security (normally this occurs at age 65), you may receive a slightly lower Social Security benefit. The extent of the impact will vary depending upon the retirement system you participate in, your salary compared with the Social Security wage base and the number of years until you retire.
How do I waive premium conversion?
You should obtain, complete and return a waiver/election form to your HR Department. You may waive participation in premium conversion (or elect to participate, if you previously waived) during the annual Open Enrollment.
How much smaller will my Social Security benefit be?
The small reduction in Social Security benefits is greatly outweighed by the much larger tax savings. In each case we tested, the increase in take-home pay far exceeded the minor loss in monthly Social Security benefits.
Here is a simple formula you can use to estimate the difference in your Social Security benefit:
Take the number of years you will participate in premium conversion (from now until your estimated retirement) and divide by 35.
Multiply this by your current annual health premium
Multiply the result of Step 2 by the marginal SSA rate (15% for most Federal employees)
The result is the annual loss of Social Security benefits.
For more specific information on how the Social Security benefit is calculated, refer to https://www.ssa.gov/