Tax Breaks for Paying Medical Expenses

If you or your family has an illness or other medical condition, taxes are the last thing on your mind. However, you may be eligible for a number of tax breaks that may be helpful for your family.

1. Deduction for medical costs

A serious illness or an ongoing chronic condition can result in substantial medical costs. While insurance may cover some expenses, you still have to pay for deductibles, co-payments, and non-covered expenses. For example, if your spouse has a medical condition for which a doctor recommends they have a home health aide, most insurance, including Medicare, won’t pay the bill. These costs, as well as other out-of-pocket costs, are deductible if you itemize your deductions.

Unreimbursed medical costs are deductible to the extent they exceed a threshold amount. For 2016, the threshold is 7.5% of adjusted gross income (AGI) if you (or your spouse) are 65 or older by the end of the year. For all other taxpayers, the threshold is 10% of AGI. Starting in 2017, the threshold for all taxpayers will be 10% of AGI.

2. Tax-free disbursements from HSAs and FSAs

If you have a medical FSA through work or a health savings account, you can use the funds from your account to cover out-of-pocket medical costs. These disbursements are tax free.

Be sure that you’re using the funds from your accounts for qualified medical expenses. Generally, most costs that could be treated as an itemized medical deduction also qualify for a tax-free disbursement from these accounts, but there are some differences. For FSAs, you can check with the plan administrators. For HSAs, check IRS Publication 969.

3. Hardship withdrawals from 401(k)s

Qualified retirement plans, as the term implies, are intended for retirement income. However, plans won’t lose their qualified status if they permit distributions on account of a financial hardship. This means having an immediate and heavy financial need defined by the terms of the plan. Usually, plans permitting financial hardships include distributions for medical and funeral costs.

However, while plans are permitted to make such distributions, hardship distributions remain taxable to the same extent as if they’d been distributed in retirement. However, if you are under age 59-1/2, you may be able to avoid the 10% early distribution penalty because there’s a penalty exception for distributions used to pay medical costs exceeding the itemized deduction threshold. There’s also a penalty exception on account of disability.

4. Penalty-free withdrawals from IRAs

While it’s advisable to let retirement savings plans to grow in order to provide retirement income, having medical costs may force you to tap into your plans. Again, as in the case of hardship withdrawals, taking money from IRAs to pay your medical bills may be necessary; the tax results are the same as for 401(k) hardship distributions: withdrawals are taxable (assuming they relate to tax-deductible IRAs) but the exception to the 10% early distribution penalty can apply.

5. More time for IRA rollovers

The tax on IRA distributions can be avoided if funds are rolled over to a new IRA (or qualified retirement plan) within 60 days. This deadline can be extended by the IRS in certain limited situations. One of these is because the taxpayer or a close family member was having medical issues that prevented the taxpayer from making the timely rollover. Here are some examples where the IRS has given a taxpayer more time to complete a rollover:

• A taxpayer had a neurodegenerative condition, exacerbated by damage to his home by Hurricane Sandy, that impaired his ability to complete the rollover within 60 days
• A taxpayer’s father-in-law suffered from dementia and she was his caregiver, preventing her from completing a rollover within 60 days
• A taxpayer had several medical conditions, both physical and mental, that would be considered disabling and that prevented her from completing a rollover on time

6. Reasonable cause for avoiding penalties

If you fail to file a return on time or take other actions in a timely manner, you usually are subject to penalties. However, in some cases, the IRS can abate penalties if you can show reasonable cause for the lateness. One explanation of reasonable cause is for medical conditions.

In order to abate penalties for the failure to file a return on time, it’s necessary to show that the medical condition was very severe; ordinary illness usually won’t do. For example, in one case a taxpayer suffering from various mental disorders, including bipolar disorder and post-traumatic stress disorder, did not show reasonable cause because he was still able to manage his rental properties despite these conditions. However, where another taxpayer’s leg injury confined her to a hospital and rehabilitation center, she proved reasonable cause because the condition prevented her from accessing her tax records.

Conclusion

When someone is ill, the focus is and should be on health. But the matter of taxes doesn’t go away, and needs to be addressed. Be sure to explore how health issues can intersect with taxes for your advantage.