Employer-paid premiums for health insurance are exempt from federal income and payroll taxes. Additionally, the portion of premiums employees pay is typically excluded from taxable income. The exclusion of premiums lowers most workers’ tax bills and thus reduces their after-tax cost of coverage. This tax subsidy partly explains why most American families have health insurance coverage through employers.
Other factors play a role though, notably the economies of group coverage.
ESI Exclusion is Worth More to Taxpayers in Higher Tax Brackets
Because the exclusion of premiums for employer-sponsored insurance (ESI) reduces taxable income, it is worth more to taxpayers in higher tax brackets than to those in lower brackets. Consider a worker in the 12 percent income-tax bracket who also faces a payroll tax of 15.3 percent (7.65 percent paid by the employer and 7.65 percent paid by the employee). If his employer-paid insurance premium is $1,000, his taxes are $254 less than they would be if the $1,000 were paid as taxable compensation. His after-tax cost of health insurance is thus $1,000 minus $254, or $746. In contrast, the after-tax cost of a $1,000 premium for a worker in the 22 percent income-tax bracket is just $653 ($1,000 minus $347). Savings on state and local income taxes typically lower the after-tax cost of health insurance even more.
These examples assume that workers bear the full burden of employer payroll taxes. Note that the effective marginal tax rates (25.4 percent for the worker in the 12 percent income-tax bracket and 34.6 percent for the worker in the 22 percent income-tax bracket) are less than the sum of the income-tax and payroll-tax rates (27.3 percent and 37.3 percent, respectively) because those rates are applied to compensation after the employer’s share of payroll taxes has been deducted. Thus, for example, if the employer increases compensation by $1,000, cash wages only increase by $929 [calculated as $1,000 / (1 + employer payroll tax rate)], because the employer would have to pay additional employer payroll taxes of $71. The lower-wage worker’s resulting combined income and payroll tax would be 27.3 percent of $929, or $254. The higher-wage worker’s resulting combined income and payroll tax would be 37.3 percent of $929, or $347. The example assumes the higher-wage worker has earnings below the maximum amount subject to Social Security taxes.
ESI Exclusion is Costly
The ESI exclusion will cost the federal government an estimated $299 billion in income and payroll taxes in 2022, making it the single largest tax expenditure. Note, too, that the open-ended nature of the tax subsidy has likely increased health care costs by encouraging the purchase of more comprehensive health insurance policies with lower cost sharing or with less tightly managed care.
Replacing the ESI exclusion with a tax credit would equalize tax benefits across taxpayers in different tax brackets, as well as between those who get their insurance through their employers and those who obtain coverage from other sources. Making the credit refundable would extend that benefit to those whose tax liability falls below the value of the credit. And designing the credit so that it does not subsidize insurance on the margin (i.e., to be a fixed dollar amount as opposed to a percentage of the premium) could lower health care costs. However, removing the link between the subsidy and employment status may weaken the incentive for firms to provide health insurance coverage for their employees.
Updated January 2024
Further Reading
Burman, Leonard E., and Jonathan Gruber. 2005. “Tax Credits for Health Insurance.” Tax Policy Center Issues and Options Brief 11. Washington, DC: Urban-Brookings Tax Policy Center.
Burman, Leonard E., Jason Furman, Greg Leiserson, and Roberton Williams. 2007. “The President’s Proposed Standard Deduction for Health Insurance: An Evaluation.” Washington, DC: Urban-Brookings Tax Policy Center.
Gruber, Jonathan. 2011. “The Tax Exclusion for Employer-Sponsored Health Insurance.” National Tax Journal 64 (2, part 2): 511–30.
Joint Committee on Taxation. 2022. “Estimates of Federal Tax Expenditures for Fiscal Years 2022-2026.” JCX-22-22. Washington, DC.
FAQs
Employer-paid premiums for health insurance are exempt from federal income and payroll taxes. Additionally, the portion of premiums employees pay is typically excluded from taxable income. The exclusion of premiums lowers most workers' tax bills and thus reduces their after-tax cost of coverage.
How does employer-sponsored health coverage affect taxes? ›
Employers deduct premium payments from your paycheck before taxes, which lowers your taxable income. Contact Covered California for help getting enrolled or if you have other questions.
What are the IRS rules for HRA? ›
HRA reimbursem*nts are excludable from the employee's income and wages for federal income tax and employment tax purposes. An employer may allow funds that remain in the HRA at the end of the year to carry over into future years.
Is employer reimbursem*nt for health insurance premiums taxable? ›
When an HRA complies with federal rules, employers can reimburse medical expenses, such as health insurance premiums, with money free of payroll taxes for both the employer and employee. An HRA is also free of income tax for the employee.
Can I deduct employer health insurance premiums? ›
If you paid the premiums for a policy you obtained yourself, your health insurance premium is deductible when they are out-of-pocket costs. If your insurance is through your employer, you can only deduct these: Amounts you paid with after-tax funds.
What are some disadvantages of employer-sponsored health insurance? ›
Lack of flexibility
Because the employer chooses group insurance, employees don't have a say in what network they'll be on, the deductible they'll need to meet, or the premium they'll have to pay.
How employer-sponsored health insurance is a benefit? ›
Employer-Sponsored Health Insurance
Your employer will typically share the cost of your premium with you. Advantages of an employer plan: Your employer often splits the cost of premiums with you. Your employer does all of the work choosing the plan options.
How does an HRA affect my taxes? ›
HRA reimbursem*nts are generally not taxable.
The IRS generally does not tax reimbursem*nts employees receive from an HRA. An exception is when employers reimburse non-medical expenses. The IRS considers that to be deferred compensation and, therefore, taxable to the employee.
How does HRA work with insurance? ›
It's an employer-funded group health plan that your employer contributes a certain amount to. You use the money to pay for qualifying medical expenses up to a fixed dollar amount per year. Unused funds may carry over from year to year. The amount you pay for your health insurance every month.
How are employer paid premiums for employee group health insurance normally treated for tax purposes? ›
Employer-paid premiums for health insurance are exempt from federal income and payroll taxes. Additionally, the portion of premiums employees pay is typically excluded from taxable income.
If there's a difference between the amount of the premium tax credit you used during the year and the amount you actually qualify for, it will impact your refund or the amount of taxes you owe. You'll include Form 8962 with your federal tax return. Get details on how to reconcile.
What is the difference between HRA and HSA? ›
HSAs, or Health Savings Accounts, are owned by the individual. HRAs, or Health Reimbursem*nt Arrangements, are agreements that are owned by employers. As such, there are key differences, including: An HSA can be funded by both the employee and employer, while only the employer funds an HRA.
How do I know if my health insurance premiums are pre-tax? ›
Pre-tax premiums can be identified by reviewing an employee's pay stub. Each stub contains important information regarding the employee's gross salary or wages, federal income tax withheld and deductions for employer-sponsored benefits.
How are employer contributions to health reimbursem*nt accounts treated in regards to taxation? ›
Generally, contributions made by an employer to the health savings account (HSA) of an eligible employee are excludable from an employee's income and are not subject to federal income tax, Social Security or Medicare taxes. In addition, employer contributions are deductible as a business expense to the company.
What employer-paid benefits are taxable? ›
Fringe benefits such as bonuses or reimbursem*nts that are paid in cash are likely to be subject to income tax. Benefits received in-kind are usually not subject to taxation. Employers often provide other employee benefits such as health plans, unemployment insurance, and worker's compensation.
Is it worth claiming medical expenses on taxes? ›
Normally, you should only claim the medical expenses deduction if your itemized deductions are greater than your standard deduction (TurboTax can also do this calculation for you). If you elect to itemize, you must use IRS Form 1040 to file your taxes and attach Schedule A.
Does health insurance affect tax returns? ›
Whether you get financial help or not, health coverage is part of filing your taxes. Unless you report that you had health coverage, you may have to pay a state tax penalty. If you received federal or state financial help, you'll report that as well.
What is the tax advantage to obtaining health insurance through the employer? ›
If an employer pays the cost of an accident or health insurance plan for his/her employees (including an employee's spouse and dependents), then the employer's payments are not wages and are not subject to social security, Medicare, and FUTA taxes, or federal income tax withholding.
How does box 12 W affect taxes? ›
The amount with code "W" in box 12 in your W-2 is the sum of the contributions your employer made and that you made through a payroll deduction scheme. However, the IRS, by default, assumes that these contributions are taxable until you complete the form 8889.
Is employer-sponsored life insurance taxable? ›
The IRS doesn't include employer-provided life group term life insurance coverage up to $50,000 in your taxable income, and won't increase your income tax liability. If your policy exceeds $50,000, though, the employer-paid cost is included in the taxable wages reported on your Form W-2.
