health insurance

$1 Billion in Health Insurance Rebates: Taxable or Tax-free?

Many Americans are about to get money back. We sort through how much they can keep.

American health insurance companies are about to shower over $1 billion in rebates on policyholders -- refunding premiums paid in 2011 that fail to meet the so-called 80/20 rule imposed by the health care reform law. If you're among the lucky recipients, will the rebate be a double-edged sword? Will it be considered taxable income?

We'll get to that. But first a quick review of what's going on.

Under that 80/20 rule, health insurers are required to use no more than 20% of premiums for overhead and profit, with at least 80% going to cover the cost of health care and quality improvements. For large group plans -- those covering more than 50 employees -- a more stringent standard applies. They must spend at least 85% of premiums on health care and improvements. To the extent a company misses the mark, it must rebate sufficient premiums to bring it into line.

Based on data for 2011, the federal government says insurers will rebate about $1.1 billion to 12.8 million Americans. The average rebate for households that get one will be about $151. The rebates are to be made by August 1.

The table at the end of this story shows the average rebate by state for families who will be receiving one. A new tool, developed by the Department of Health and Human Services, will help you determine whether you'll get a rebate, based on your insurance company and whether you're covered by an individual policy or a small- or large-group employer plan. (Workers covered by an employer who is self-insured -- ask your human-resources department -- are not eligible for rebates.)

Taxable or tax-free?

As with most tax matters, the answer is: It depends. The principle here is easy to understand. If you got a tax break for money spent in 2011 and you get some of that money back in 2012, Uncle Sam wants to retrieve part of the tax break, too. Putting this principle into practice gets tricky, though.

Individual policies If you had an individual policy in 2011, the tax status of any rebate will turn on whether you deducted the premiums you paid. If you're among the two-thirds of all taxpayers who claimed the standard deduction rather than itemizing, you can be sure the rebate will be tax-free.

Even if you itemized, there's a good chance it will be tax-free because three-fourths of all itemizers do not deduct medical expenses. That's because you can do so only if your qualifying expenses (including health insurance premiums) exceed 7.5% of your adjusted gross income.

If you did deduct medical expenses, however, all or part of the rebate will be taxed. How much depends on how much your total itemized deductions exceeded the standard deduction for your filing status.

Group plans If you get your health insurance at work, the tax treatment of a rebate will depend on how you paid your share of the cost of health insurance and how the rebate is delivered.

If you paid the premium with after-tax dollars, the rebate will be tax-free.

If, as is common, your employer has a program to allow employees to pay their health care premiums with pretax dollars, then the rebate will be taxable.

If your employer gives you your share of the rebate as cash, that amount will be treated as extra 2012 compensation -- it will show up on your Form W-2 -- and both income tax and Social Security tax will be withheld. (This settles the score because in 2011, when the pretax money was used to pay the premium, that amount avoided income and Social Security taxes.)

Your employer might instead use the rebate to reduce your health premiums in 2012. That might sound like a way around the taxing issue, but it's not.

Let's say your rebate is $100 and that income and Social Security taxes take a total of 30% of your pay. If you get cash, $100 will be added to your compensation and that will cost you an extra $30 in tax. If the rebate is used to reduce your premiums, $100 less of your salary will be deducted before taxes to pay premiums this year ... and that means your taxable pay will be $100 higher than if the rebate hadn't applied. That, in turn, will increase your tax bill by $30.

In both cases, though, you'll be $70 ahead.

Source: U.S. Department of Health and Human Services.

Sneak preview: New tax benefits -- as well as burdens -- for 2012

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