Fighting a major illness or injury can be enormously expensive, but you can find some help in the tax law.
Medical expense deductions. Although everyone knows medical expenses are deductible, in truth very few taxpayers actually get to deduct them. The catch? You must itemize deductions to write off medical expenses, and only about 25% of taxpayers itemize. And, such costs are deductible only to the extent they exceed 7.5% of your adjusted gross income (AGI). So, if your AGI is $50,000, the first $3,750 of unreimbursed medical expenses don't count. If you, your spouse or your dependent children are facing a major illness or injury, however, you may well surpass the 7.5% threshold. If so, be sure you tote up all your qualifying expenses.
HSA and MSA distributions. If you have a health saving account or an Archer Medical Savings Account, withdrawals used to pay qualifying medical expenses are tax-free.
Flexible spending account. Generally, employees are allowed to adjust the amount of salary earmarked for a medical reimbursement account only once a year. If during your open-enrollment season you anticipate higher medical bills in the year ahead, consider increasing the amount of money you set aside. Salary diverted into a reimbursement account and then used to pay medical bills escapes both income and Social Security taxes.
There is currently no legal limit on how much can be set aside, but most companies set a limit of $5,000 or less per year. A $5,000 set-aside that avoids a 25% federal income tax rate and the 75.65% Social Security and Medicare tax would save you more than $1,600500. Any state tax savings would make this an even better deal. Note that starting in 2013, the law will cap contributions to medical FSAs to $2,500 a year.
IRA and 401(k) plan payouts. Although using retirement funds for anything other than retirement is generally discouraged, crushing medical bills could force you to tap your account. If you tap a traditional IRA before age 59½, the 10% penalty that normally applies to payouts before age 59½ is waived to the extent that you have qualifying medical expenses in excess of 7.5% of AGI.
The same goes for early withdrawals from 401(k)s, although such withdrawals are difficult to make if you are still on the job. "In service" withdrawals are only allowed if you can meet hardship requirements. If you have left the job in a year in which you were age 55 or older, the 10% penalty doesn't apply regardless of the 7.5% rule. Even if you avoid the penalty, your IRA or 401(k) withdrawals will be taxed as income.
Disability insurance payments. If your condition results in your receiving benefits under a disability insurance policy, the taxability of the income depends on who paid for the policy. If you paid, the benefits are tax-free. If your employer paid for the insurance, the benefits are fully taxable.
Damages. If you receive a settlement in a damage suit that includes money for medical expenses you deducted in an earlier year, that amount is considered taxable in the year you receive it but only to the extent that the deduction actually reduced your taxable income for the year you wrote off the expenses. If a settlement includes funds for future medical expenses, the amount is not taxable. Those future medical expenses aren't deductible either until they exceed the amount of the award allocated to future medical care.
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