Itemized Deduction for Medical Expenses

Americans that spend high proportions of their income on medical expenses are entitled to deduct those above 7.5 percent of income from personal taxes. The savings amount to nearly $1,000 off the cost of medical care per person.

The itemized deduction for medical expenses was first introduced in 1942. It allows taxpayers to purchase health care services with pre-tax funds – $65 billion (in contrast, flexible spending accounts and health savings accounts amount for only $25 billion and $1 billion, respectively).  Under present conditions, the deduction is available once medical expenses exceed 7.5 percent of a tax filer’s income.

As a result of the Affordable Care Act, the threshold for the deduction will be increased to 10 percent of income beginning 2013. Many of the calculations in this study reflect this 10 percent threshold and therefore provide adequate estimates of the itemized deduction for medical expenses as health reform implementation continues.

Data analysis for this study comes from a stratified probability sample of individual tax returns from years 2000 to 2006. The sample includes 1.3 million tax filers. Additional information on health care expenses comes from the Medical Expenditure Panel Survey.

In 2003, over 19 percent of non-elderly households spent more than 10 percent of their income on medical expenses. Fewer than one-half (41 percent) of tax filers with significant medical expenses took the itemized deduction. The median deduction was $3,900. By comparison, the median deduction for mortgage interest was $5,300. The results of these savings amounts to $951 off of a tax filer’s annual medical expenses (approximately $11,551).

Analysis also indicates that the elderly are the most likely to take the medical expenses deduction; they take the deduction twice as often and receive a deduction twice as large as any other age group. The elderly account for 39 percent of all those seeking the tax deduction for medical expenses. When the floor for seeking the deduction increases to 10 percent of income in 2013, elderly filers will still be more likely to take the deduction.

The authors note that from year-to-year, the elderly remain more likely to continue claiming the medical expense deduction.

Commentary

There are several tax breaks to encourage the use of health care. First and foremost is the tax exclusion for employer provided health care. However, a significant portion of health spending comes from after-tax sources (i.e. out-of-pocket spending). Mechanisms to convert this to spending to tax-preferred status include health savings account, flexible spending accounts, and the itemized deduction for medical expenses beyond 7.5 percent of gross income.

This study shows that of eligible tax filers, fewer than one-half utilize the tax deduction. A significant portion of these individuals are elderly – likely because this population tends to have lower incomes and higher medical expenses.

While we have discussed in the past, the preferential tax treatment of health insurance accounts for significant lost revenue for the federal government while also distorting the health care market in the favor of employees with higher incomes.

The unequal treatment of health care expenses – before-tax for employees and after-tax for self-insured Americans –  should be remedied. During the reform debate over the it became clear that Americans prefer to have the health care provided tax-free, at least up to a point.

Perhaps the itemized deduction for medical expenses should be replaced with one that begins at the first dollar spent and cuts off at a reasonable level. It could be made to mirror the “Cadillac Tax” which imposes a 40 percent rate on health insurance costing more than $10,200 for individuals and $27,500 for families (beginning in 2018). If constructed in this manner, all Americans would have access to tax-preferred health care while limiting over-utilization.

Lurie IZ, Minicozzi A. “Understanding the increasingly popular itemized deduction for medical expenses.” Med Care Res Rev. 2010 Dec; 67(6):707-21.

by

Cedric Dark, MD, MPH