Hamill: Understanding the self-employed health insurance deduction

Question: My son lives in Arizona and receives pension income from the Arizona Retirement System (ARS). He is 64 years old and is now single with no dependents. The ARS allows him to purchase health insurance at group rates provided he pays 100% of the cost. The insurance premiums are taken from his retirement payment each month.

He recently started teaching part time, and he is paid on a contract basis on an IRS Form 1099. He typically makes about $500 per month from this activity. We are both trying to figure out the IRS Form 7206 for a self-employed deduction for health insurance. He appears to qualify. This deduction would really help because he doesn't have enough medical expenses to get any tax benefit from itemizing tax deductions. Can you explain how this deduction works?

In general, self-employed people can deduct 100% of their health insurance premiums as adjustments to their gross income.

If available, the deduction reduces taxable income without the need to itemize deductions or to have medical expenses more than 7.5% of adjusted gross income.

When your son was employed full time, he was probably eligible to participate in an employer-sponsored health plan.

The tax law allows employer contributions to health insurance to be excluded from the employee's income.

The employee's share of the health insurance cost is also paid with pre-tax dollars. Many Americans rely on employer-sponsored health plans for their insurance coverage.

There was a time when self-employed people could deduct their health insurance only as an itemized medical expense. Most then received no tax benefit.

This was not equitable treatment compared to employees, and Congress decided to create a deduction for the self-employed.

Initially this deduction was limited to 25% of the premiums paid, but over 20 years ago, it was increased to 100% of the premiums.

The purpose of the deduction was to create parity between the employed and the self-employed.

If a self-employed person is eligible to participate in an employer-sponsored plan, there is no need to duplicate a tax benefit.

The self-employed tax deduction is then not available if the person is also eligible to participate in an employer-sponsored plan.

Of course, if the person did participate in the employer's plan there would be no need to duplicate coverage.

But the law restricts any self-employed deduction based on eligibility to participate, not actual participation.

A married person or a dependent under age 26 might be eligible to participate in a spouse's or a parent's plan.

Your son is no longer an employee of the Arizona employer that made him eligible for the ARS health coverage.

The ARS coverage is not made available through an employer plan. Medicare is also not an employer plan.

Perhaps your son will opt for Medicare coverage when he becomes eligible at age 65.

Any health premiums paid to ARS or, later, to Medicare, would be eligible for the self-employed health insurance deduction.

The deduction is limited to the net earnings from self-employment. He would start with the net income reported on IRS schedule C.

His income is subject to self-employment (SE) tax. He is allowed to claim a deduction for one-half of the SE tax paid.

The self-employment earnings might also allow him to fund a retirement plan such as a simplified employee pension (SEP).

The maximum deduction for self-employed health insurance is the income from the business reduced by the SE tax deduction and, if applicable, any SEP contribution.

For example, let's say your son's schedule C income for the year is $6,000. He pays $847 SE tax and deducts $424 of that tax.

His health insurance deduction is then limited to $5,576. If he also funds a $1,000 SEP contribution, the deduction is reduced to $4,576.

Any premiums more than the allowed self-employed deduction are available to be claimed as itemized deductions.

An SEP contribution is usually made to claim a tax deduction. If the deduction reduces his health insurance deduction, there is no net benefit from the SEP deduction.

An SEP, like an IRA, allows tax-free growth of the investment. If there is no net benefit to the deduction, your son could instead fund a Roth SEP, or IRA.

The Roth provides no tax deduction but creates the opportunity for tax-free investment growth.