Deducting Medical Insurance

I first discovered I could deduct medical insurance when I had an emergency operation in 2009 that saved my life. The operation, and the subsequent hospital stay, left me with over 60 thousand dollars in medical debt.

After this life-saving event, I was paying off both medical debt and paying for health insurance at the same time. So, quite naturally, I started itemizing my medical expenses on Schedule A. Schedule A, generally speaking, is where you itemize deductions of all kinds.

After I paid off my medical debt, I assumed there was no further benefit to me filling in the medical insurance part of my tax return. I made this assumption based on the fact that my yearly total for medical insurance never reached the level of the standard deduction. Since I was no longer filing Schedule A, and no longer itemizing deductions, I assumed there was no way I could use medical insurance to reduce my taxes.

I was wrong, totally wrong.

It turns out that if you are a small business owner and you do not itemize your deductions on Schedule A, there is still a place to put your medical insurance expenses. That place is Line 29 of Form 1040, long form.

Here's the IRS's rather complicated explanation of line 29:

Health Insurance Tax Breaks for the Self-Employed

Why give small business owners two places to place medical insurance payments? I've tried to figure out the IRS's reasoning on this:

It seems to me that you can place medical insurance payments in 2 different places because this gives small business parity with wage earners. This is especially true for sole proprietors.

When you are an employee for a company, the medical insurance that the company buys for you is an expense. Effectively, medical insurance lowers your wages and thus lowers your taxes. That's my best guess.

Therefore, as a sole proprietor, health insurance should also lower your taxes, even though you pay it yourself. That, to me, seems to be IRS reasoning on the matter.

It makes sense. Whether you are an employee or self-employed, medical insurance should lower your tax burden equally. I believe line 29 of Form 1040, long form, is the equalizer.

Why not have everyone deduct everything medical, including health insurance, exclusively on Schedule A? The reasoning on this is probably that most people do not have enough deductions to itemize on Schedule A. Most people take the standard deduction instead.

So, if there were no special provision for the self-employed to deduct medical insurance that they pay for themselves, there would be no fairness of treatment of wage-earners and the self-employed.

Without line 29, wage earners would be at an advantage over the self-employed because medical insurance is always going to lower their tax burden, but medical insurance would not necessarily lower the tax burden of the self-employed if it were not for line 29 as a special provision.

Admittedly it requires a very broad understanding of economics to understand how health insurance could lower a wage-earners wages and therefore lower the wage-earners taxes. Basically it has to do with the fact that both wages and health insurance are an expense for a business. If health insurance goes up in cost, it suppresses wages because the business owner has to pay the expense, regardless.

How are wages determined? Mostly by the marketplace. The market for wage earners determines how much wage earners earn. For example, in the big city the competition for wage-earners is more intense and thus wage-earners tend to earn bigger hourly rates or bigger salaries.

Health insurance increases the expense to employers and therefore decreases potential wages for all employees when the cost of health insurance goes up. It's simple supply/demand economics.

Of course, there will be those who dispute this. However, even though determining the level of someone's wages is a very approximate thing, it still balances out. A business can never pay employees more than the business receives in revenues. Health insurance also counts against those revenues.

So, in a very approximate way, rising health insurance costs suppress wages. Maybe not this year, but eventually. Eventually it all comes out in the wash as they say.

The over-riding principle of tax forms seems to be balance. Allowing medical insurance payments to be included on line 29 instead of Schedule A is an attempt to bring balance to a highly imperfect tax code. That's my best guess.

Of course, life is never perfectly fair on Earth. However, I do appreciate it when people at least try to be fair.

By the way. You cannot place your medical insurances on both line 29 and Schedule A. You know that, right? I mention this only for extra crystal clear clarity. If you could place medical insurance payments on both line 29 (Form 1040) and Schedule A, the principle of balance would go in reverse. Now small business owners would have the tax advantage over wage earners.

None of the above is written with the intent of suggesting that the tax code is perfectly fair. Rather the intent is to show that even when people are not fair, life somehow is. That is to say, life itself is always seeking a balance in all things.

Ed Abbott

Can I Be Claimed as a Dependent on Someone Else's Return?

I'm trying to figure out today whether or not a person who lives with a relative can be claimed as a dependent. Here's a great resource that attempts to answer this question:

Rules for Claiming a Dependent on Your Tax Return

It looks like their are 2 reasons why you might be claimed as a dependent on someone else's tax return:

1. Qualifying child
2. Qualifying relative

Interestingly enough, a child that does not qualify as a qualifying child can still qualify as a qualifying relative. However, a child that qualifies as a qualifying relative must be almost entirely without income. This page gives more detail:

Claiming an Adult Child as a Dependent on Your Taxes

Apparently, almost entirely without income is $3,900 for tax year 2013. That's the limit. Where does this figure come from? It is the amount of your personal exemption. In 2013, the personal exemption amount is printed on line 42 of Form 1040, long form. It is also in the instructions for Form 1040 under the sub-heading Exemptions.

As I understand it, someone over the age of 24 is unlikely to be a qualifying child --- the one exception being if that child is completely and totally disabled. This makes it easy in that the only way most adult children who are over the age of 24 can qualify is if they have almost no personal income.

To find out if an adult child qualifies as a qualifying relative, find out if the adult child had less income than the personal exemption amount for the tax year --- $3,900 or less income in tax year 2013.

I'm not a tax expert. I'm just someone trying to figure out my own taxes. When I finally figure something out, I write about it on this blog. To get real tax advice, you should go to a real tax professional or call the IRS on the phone.

Like so many issues, the issue of being a dependent on someone else's return is complicated until it becomes simple. The simplicity of being claimed on someone else's return can be boiled down to these basic principles:

1. Only a child who is 24 or under can ever be considered a qualifying child unless that child is completely and totally disabled
2. If the child has quit going to college, the limitation on the age of the child who is considered a qualifying child is 19, not 24
3. An adult who is over the age of 24 can still be a qualifying child if the child is completely and totally disabled. However, this is beyond the scope of this article. Look elsewhere for more information.
4. A child who is not a qualifying child can still be considered a qualifying relative
5. In general, limitations on income for a qualifying child are less strict than limitations on income for a qualifying relative
6. A qualifying relative can only earn up to the limits of the personal exemption amount. If the qualifying relative made more than $3,900 in 2013, he is no longer a qualifying relative, but could still possibly be a qualifying child
7. In short, a qualifying child is allowed to earn more money than a qualifying realitve

Tax law can be quite complicated. However, even tax law has its own logic.

If you notice any errors here, please post below. I will attempt to correct my errors. This is not an expert blog. It is a blog by a tax novice who is writing for his own understanding.

Ed Abbott

What Is Earned Income?

What is earned income? I was trying to figure this out the other day. Here's how the IRS defines it:

What is Earned Income?

Earned income is anything you can do with a shovel. That's the image I get. If you can shovel your way to your earnings, it is earned income.

Farmers use shovels. Farming is earned income. If you are a contractor, you might occasionally use a shovel. General contractors, who own their won business, have earned income.

Sold stock in the stock market at a profit? No earned income there. No need for a shovel either. Earned interest on your bank account? That's not earned income either.

The shovel analogy only goes so far. If you work in an office pushing a pen, that too is earned income. In fact anything that you get W-2 wages for is earned income.

In terms of the tax code, earned income seems to show up in two places:

1. On the W-2 form your employer sends you
2. On Schedule C (business income) that you fill out

So whether you own your own business, or someone pays you to help them with theirs, it is earned income.

What is not earned income? If you sell that old Vincent Van Gogh painting you've been storing in your attic, that is not earned income. That's a capital gain.

So anything that becomes more valuable over time and that you sell for a profit is not earned income. At least, that's how I understand it.

In terms of the tax code, Schedule B (interest and dividends) and Schedule D (capital gains) are not earned income.

Even though the shovel analogy I started with in not perfect, it still helps me understand earned income. Earned income is grunt work. If you have to sweat a little bit to earn it, it's almost certainly earned income.

Flipping burgers over a hot stove is earned income. Trading stocks in your stock brokerage account while sitting in front of your computer is not earned income.

What if you are a soldier? Soldiering is definitely grunt work. And it is definitely earned income.

The guiding principle that seems to govern earned income is labor. If your dollars are from labor, and not from luck or circumstances, it is earned income. Even if you make your own luck, it is not earned income

I have to believe that the whole concept of earned income gets a little bit murky at times. Surely someone who owns a retail store that buys items at cost and sells them for a profit has earned income.

But what about a retail store that buys and sells antiques? I would imagine that that is earned income as well. I'm not an expert. I'm just guessing.

At what point the buying and selling of items becomes a retail operation and not a capital gain is unclear to me. If that's your question too, you should probably ask someone who knows far more than I do.

When I get into trouble with tax issues, I consult a tax professional.

Update: May 13, 2014

I just came across the most succinct definition of earned income I've seen so far:

Earned income includes wages, salaries, tips, professional fees, and other compensation received for personal services you performed. It also includes any amount received as a scholarship that you must include in your income. Generally, your earned income is the total of the amount(s) you reported on Form 1040, lines 7, 12, and 18, minus the amount, if any, on line 27.

Finally! A simple definition for earned income. The paragraph above is quoted from the 2013 instructions for Form 1040. Specifically, it is from the Standard Deduction Worksheet for Dependents, a worksheet associated with line 40 of Form 1040, long form. This worksheet is found on page 39 of the instructions

I like this definition for earned income because it is expressed in terms of Form 1040 line numbers. In my own mind, the above definition translates to a simple arithmetic formula:

1. Add wages (line 7)
2. Add business income (line 12)
3. Add farm income (line 18)
4. Subtract the deductible part of self-employment tax (line 27)

The result is your total earned income

While the above definition is not sufficient for all people, it does give general insight into what earned income is. Furthermore, this definition is probably sufficient for most wage earners and most self-employed people. In fact, most wage earners can probably skip the last 3 steps and just focus on step 1, add wages. For a wage-earner, the only component of their earned income is, I'm guessing, the figure found on their W-2, their wages for the year.

For some of us, earned income is a bit more complex. Here's another IRS paragraph that gives further insight into what earned income is:

Earned income includes net earnings and gains from the sale, transfer, or licensing of property you created. However, it does not include capital gain income. If you were a more-than-2% shareholder in the S corporation under which the insurance plan is established, earned income is your Medicare wages (box 5 of Form W-2) from that corporation.

The above paragraph is from the Form 1040 instructions for 2013. It is from the Self-Employed Health Insurance Deduction Worksheet found on page 31 of the instructions. The worksheet calculates the amount for line 29 on Form 1040.

The above paragraph appears to me to be directed at people who own their own private corporation, a so-called S Corporation. I do not own my own corporation so this does not apply to me.

However I do find the part about property you create helpful. It sounds to me like an artist who paints a painting and sells it has earned income, not a capital gain. This is only common sense.

Later, however, the person who bought it might sell it for a capital gain after the art appreciates in the marketplace as time goes by.

Again, it appears that the essential component of earned income is grunt work. In this case, the artist's shovel is his paintbrush.

Ed Abbott

How Much Can I Contribute to My Roth IRA?

I'm totally confused! Is adjusted gross income the primary determinant of how much of your earned income is eligible for your Roth IRA or is it not?

Here's a nice article that suggests that adjusted gross income is very important in determining how much of your earned income can be contributed to your Roth IRA:

Roth IRA Rules

OK. I just reread the article and I think I finally understand. I now understand that there is more than one ceiling (limitation) on your annual Roth contribution. Here are the ceilings on your Roth IRA contribution limit as I understand them:

Ceiling #1:The first ceiling is the maximum amount of money anyone in your tax filing status is allowed to contribute to their Roth IRA. For example, some people will be limited to $5,500 in 2014. This is probably the most commonplace ceiling that hangs over the most people.

Ceiling #2:The second ceiling is how much you contributed to your other IRA, your Traditional IRA. Whatever you contributed to your Traditional IRA gets taken off the amount you contribute to your Roth IRA. In effect, this ceiling interacts with all the other ceilings by lowering them.

Ceiling #3:The third ceiling is if you have more income than the average person. If that is the case, you may be subject to the MAGI ceiling described in the above article. If this ceiling kicks in because you are earning big bucks, it will effectively nullify ceiling #1 by lowering it.

Ceiling #4:The fourth and final ceiling is the total of all your earned income. If you made only one thousand dollars mowing lawns and another 29 thousand selling a small slice of real estate, your total income is 30 thousand dollars. However, only one thousand of that 30 thousand can be set aside for a contribution to your Roth IRA. Ceiling #4 kicks in when you have very little in the way of earnings that can be called earned income. In effect, because your earnings are less than ceiling #1 for the year, ceiling #4 takes over for ceiling #1.

Thinking of the maximum Roth IRA contribution as a series of interlocking ceilings really helps me to understand. Whatever ceiling is lowest is the one that determines how much you can contribute to your Roth IRA.

It's a little bit like a tall person in a small house. Only the ceiling that the tall person bumps their head on is the one that counts. And so it is with your Roth IRA. Whatever Roth IRA ceiling is the lowest is the one that determines your Roth IRA contribution limit for that year.

Hopefully, I've more or less got the right idea on this one. For much greater expertise (I have none when it comes to taxes and tax law) I refer you to the IRS publication that, so far, seems to be the most authoritative:

Publication 590 (PDF)

I can certainly understand why some people feel our tax code is too complicated and too concept rich. The more concepts you have to absorb to fill out the forms, the harder it is for an individual to do their own taxes.

Update: May 12, 2014

I've been studying publication 590 mentioned above. Oddly enough, the publication that details IRAs does not seem to mention earned income at all. Instead, the term it uses is compensation.

As I understand it, earned income and compensation are almost the same thing, but not quite the same thing. That is to say, for most people, compensation and earned income are the same thing. That's my best guess based on what I've seen on other websites.

However, when you get into the nitty gritty of it, it turns out that for a self-employed person, compensation and earned income are similar, but not the same.

The reason for this is that self-employed people must file Schedule SE. Part of Schedule SE is that you are allowed to take a certain amount of your self-employment tax and subtract it from your personal income. In subtracting part of your self-employment tax from your income (adjusted gross income), you are also lowering your earned income as the IRS defines it.

However, for maximum IRA contribution purposes, as I understand it, while you might subtract part of your self-employment tax from your earned income, you do not subtract it from your compensation.

Again, compensation is the key ingredient you need in any given year to make a Roth IRA contribution for that tax year. That's how I understand it after reading the IRS documentation for Roth IRAs.

Therefore, since compensation is the focus of maximum IRA contributions and not earned income, you should ignore earned income in favor of compensation. That is to say, if earned income and compensation are different for you because you are self-employed, ignore earned income and focus on compensation only.

My best understanding (which may not be perfect) is that you only need worry about the distinction between earned income and compensation if you are self-employed. Otherwise, not.

I cannot guarantee I've got this right. However, on the web I see so much written about earned income and IRA contributions. Yet, publication 590 (Tradational and Roth IRAs) barely mentions earned income at all. What gives? It appears to me that compensation is the real focus of Publication 590, not earned income.

From now on, I will be focused on compensation, not earned income, when calculating my maximum IRA contribution in a year in which I earned very little money. This is because I have business (Schedule C) income.

For those of you who only have W-2 income (wages), you can probably forget the distinction between earned income and compensation. For you, the 2 are probably exactly the same thing. That's why so many websites mention earned income and Roth IRAs in the same breath. For most people, they are likely the same thing.

Update: May 13, 2014

This morning I've further solidified my concept of compensation versus earned income. I did a search on Publication 590 for these 2 terms:

• insurance
• medical

Why search Publication 590 for these 2 terms? Because I wanted to know whether or not medical insurance could potentially count against my Roth IRA contribution.

Specifically, I wanted to know whether Line 29, Self-employed health insurance deduction could possibly count against my compensation and therefore lower the amount I contribute to my Roth IRA. In 2013, Line 29 is the health insurance deduction line for self-employed people.

I searched insurance and medical in 2 separate searches. While I found lots of references to these 2 terms, none of these references suggested that taking a medical insurance deduction could ever count against your Roth IRA contribution for the year.

In short, I need not worry about my medical insurance deduction also counting against my Roth IRA contribution for the same tax year. To the best of my knowledge, medical insurance payments are not subtracted from your compensation. At least, that's how I read Publication 590.

Most of the references to medical insurance in Publication 590 are about using your Roth IRA before age 59-1/2 to pay medical bills if you lose your job. This appears to be a hardship provision. If you lose your job and you have medical bills, you can use your Roth IRA to pay these bills. This seems to be the gist of what I read.

After carefully reading Publication 590, I'm convinced that I'm at liberty to take the medical deduction on line 29 of the 2013 Form 1040 without fear that I will compromise my contribution to my Roth IRA for 2013.

Tax law is complicated, isn't it?

Ed Abbott