Pre-Tax vs. After-Tax Health Insurance: Which is Better?

When choosing between pre-tax versus after-tax health insurance contributions, determining associated financial implications forms the crux. Actual selection of health insurance is a key aspect of personal finance planning, and how one pays for their health insurance contributes to overall tax liability, take-home pay, and even long-term savings.

What Are Pre-Tax Health Insurance Benefits?

Pre-tax health insurance is contributions made on a pre-tax basis. This means that the money taken from your gross pay to pay for your health insurance is not included in your income before the IRS calculates its tax liability; rather, it's subtracted from your income to reduce your overall taxable income.

Therefore, for instance, if you earn $50,000 a year and contribute $5,000 for a pre-tax health insurance program, your taxable income would now be $45,000. What happens? Taxed on a smaller amount, which in turn may reduce the tax bill.

Effect of Pre-Tax Contributions on Your Taxes

The money you put toward health insurance, by the way, is deducted on a pre-tax basis. What that means is if you put money toward health insurance, it reduces your taxable income. In other words, you don't pay taxes on the money toward health insurance. This makes you less taxable both at the federal and state levels and at the FICA level. And when tax season rolls around, you pay less.

For example, if you contribute $2,000 to a pre-tax health plan each year, your taxable income for that year goes down by $2,000. If you are in the 22% tax bracket, that would leave you with an additional $440 in taxes saved (22% of $2,000). That's why pre-tax contributions can be very attractive to those who want to cut down their current tax burden immediately.

Tax Implications of Contributions Made With After-Tax Dollars

With after-tax health insurance contributions, the dollars paid towards your premiums are withheld from your salary after taxes have been computed. This way, it will not reduce your taxable income and you will pay taxes based on your gross salary.

While you don't get immediate tax benefits like contributions made on a pre-tax basis, there can be advantages with after-tax contributions. You might qualify for tax deductions if, for instance, you itemize on your tax return for after-tax medical expenses. Generally, you can deduct medical expenses that exceed 7.5% of your adjusted gross income or AGI, which can therefore bring down your tax liability.

Another advantage of after-tax contributions is that you have greater flexibility when choosing your healthcare options because you are not tied to one specific choice of your employer's plan options. You may also be able to contribute to a tax-deferred retirement account, such as a Roth IRA, without having your pre-tax health insurance deductibles reduced by income.

Which Option Is Best for You?

You decide whether to have pre-tax or after-tax health insurance based on your position, what you want to achieve, and what is important to you regarding flexibility and tax savings.

When Pre-Tax Contributions Are Better

Pre-tax contributions are more beneficial when you are worried about lowering taxable income so that you pay less taxes immediately. It is better for those in higher tax brackets. It is easier to lower your taxable income when you make contributions by using pre-tax contributions. For example, if you earn $100,000 and contribute $5,000 to a pre-tax health plan, you will save $1,100 in taxes (22% of $5,000). The potential for tax saving upfront is one of the principal reasons that most people elect pre-tax options.

If your employer offers a solid health insurance plan with reasonable premiums, it may be an obvious time to make contributions with pre-tax dollars. Moreover, using pre-tax dollars for an HSA or FSA can be a good way to sock away money for future medical costs.

When After-Tax Contributions Make Sense

Such contributions may work better for employees who can opt for other health insurance plans outside of a tax-favored employer-sponsored and those wanting to maximize their eligibility for tax-free growth in savings accounts like Roth IRAs.

If you're self-employed, or if your employer doesn't provide a pre-tax health plan, you are likely to pay for health insurance with after-tax dollars. If you itemize deductions on your tax return and have large medical expenses, being permitted to deduct them would counteract the benefit of not having a pre-tax benefit somewhat.

Another benefit for you with after-tax contributions is flexibility because you're not bound to the structure of an employer-provided plan. If you want control over your benefits as well as your long-term savings, this might be a better option for you.

Conclusion

The decision of whether to choose pre-tax or after-tax health insurance depends on your financial goals, the level of income, and how you intend to use the money. The most advantageous pre-tax contributions provide one with current tax relief, but it is indeed a better choice for most people who want to lower their current tax burden.

After-tax contributions offer greater flexibility and probably tax benefits for persons with higher medical expenses or other special financial needs. Whatever your choice, you need to review first your financial situation and for assistance if necessary to ensure that you have been making an informed decision.