Health Care: How does the tax exclusion for employer-sponsored health insurance work?
Employers’ payments covering premiums for employer-sponsored health insurance are exempt from federal income and payroll taxes. Any portion of premiums paid by the employee is typically excluded from taxable income and is therefore also tax-free, although some employers require employees to pay their share of premiums out of after-tax income. The exclusion of premiums lowers most workers’ tax bills and thus reduces their after-tax cost of health insurance coverage. This effective tax subsidy is a major reason why most Americans have health insurance coverage through either their own employer or that of a family member. Other factors also play a role, however, including the lower costs of group coverage and reduced administrative expenses.
- Some employers provide only access to group insurance and do not help pay premiums. Even in such cases, however, the premiums that workers pay are typically exempt from income tax.
- Because the exclusion of premiums for employer-sponsored insurance reduces taxable income, it is worth more to taxpayers in higher income tax brackets than to those in lower brackets. Consider a worker in the 15 percent bracket who also (in effect) pays a combined (employer and employee) payroll tax of 15.3 percent. If his insurance premium is $1,000, his taxes fall by $303, that is, 30.3 percent (15 percent + 15.3 percent) of $1,000. His after-tax cost of health insurance is thus $1,000 less $303, or $697. In contrast, a worker in the 25 percent bracket faces a total tax rate of 40.3 percent (25 percent + 15.3 percent). For her, the after-tax cost of a $1,000 premium is just $597 ($1,000 minus 40.3 percent of $1,000). Savings on state and local taxes could further lower the cost for both workers.
- For low-income workers who face a negative tax rate because of the earned income tax credit (EITC), the exclusion actually raises the after-tax cost of health insurance. For example, a worker with two children and earnings of $12,000 faces a net tax rate of -24.7 percent (her negative 40 percent rate due to the EITC plus the 15.3 percent payroll tax rate). If the worker excludes $1,000 paid to cover her health insurance premium, her after-tax income (before paying for health insurance) falls by $247, because she loses $400 of EITC, which is only partially offset by her savings of $153 in payroll taxes. In effect, her cost for health insurance is $1,247.
- Replacing the tax deduction for health insurance with a tax credit would equalize the tax benefits across taxpayers in different tax brackets, as well as between those who get insurance through their employers and those who obtain coverage from other sources. Making the credit refundable would extend that benefit to those whose tax liability falls below the value of the credit.