Health Care Tax Deductions for the Self-Employed

The cost of health insurance puts a significant strain on many small businesses.

The same is true for self-employed taxpayers.

The National Association for the Self-Employed claims that of the 45 million Americans without coverage today, 60% are from families in which the head of household is self-employed.

But health care is vital for the long-term stability of a small business. This is especially true if you're self-employed: How can you make money if you're the only employee and you have to call in sick?

Fortunately, a few tax deductions can help reduce the impact that premiums and health-care costs in general have on your bottom line.

The Health Insurance Premium Deduction

"Above the line" deductions are taken into account before you calculate the taxes you owe: They are the "adjustments" in your adjusted gross income (AGI) on line 37 of Form 1040, and they serve to reduce your taxable income. Itemized deductions (or the standard deduction if you elect that), on the other hand, occur "below" the line, on Line 40, and decrease the amount of tax you owe.

The entire cost of your self-employed health insurance premiums counts as an above-the-line deduction (as do student loan interest and contributions to traditional, but not Roth, IRAs). Taking this deduction can significantly reduce your federal and state tax liability, although it won't affect your Schedule C (business income) or self-employment tax calculations.

For example, if you paid $10,000 in 2007 to insure your whole family, you would enter $10,000 on line 29 of Form 1040. That move would lower your AGI by $10,000 -- so if you were in the 25% federal bracket and a 5% state bracket, it would reduce federal taxes by $2,500 and state taxes by $500.

Medical Expenses and HRAs

You must itemize your deductions (see IRS Schedule A), to deduct your 2007 medical expenses.

Even if you do itemize, you may deduct your costs only if they exceed 7.5% of your AGI. For example, if you had an AGI of $60,000 your costs would have to exceed a threshold of $4,500 (7.5% of $60,000) for them to be deductible. If you had $5,000 in medical expenses, you could deduct $500 -- the amount by which your expenses exceeded the $4,500 threshold.

You might consider setting up a Health Reimbursement Account (HRA), which can allow you to deduct all of your 2008 medical expenses and insurance premiums as business expenses. HRAs require you to have an employee or to become your own employee, something that's possible if your business is structured as a C or S corporation. HRAs involve a lot of paperwork, so consult a tax adviser to see if this strategy is right for you.

The Upside of Tax Time

HRAs aren't the only item related to 2008 taxes you might consider. "While you complete your 2007 return, think ahead to how you might do things differently for 2008," says Keith Hall.

That might involve improving how you file your business-related receipts (or deciding to organize them in the first place), increasing contributions to your retirement plan or even shifting how your business is set up (by incorporating or hiring your spouse as an employee) so that you can take advantage of more deductions.