Over the Lolo Pass with the IRS

What's more screwed up: the U.S. tax system or the U.S. health care system?

My answer to that question might depend on when you asked. If you asked me while I was filling out tax forms and helping the government tap my wallet, I'd tell you one thing. If you asked me while I was standing in line at the pharmacy, I'd tell you another.

But sometimes, it's a draw. Those are the nights, like last night, when I spend an hour or two shuffling all kinds of papers around to get reimbursed for doctor bills and prescriptions. At those moments, it's a dead heat.

I've been doing it for so long, I've got the process somewhat streamlined. But when I try to explain to family members what I'm doing, the absurdity of it all really hits home. Here's what I try to tell them:

There's a benefit in the income tax law for your out-of-pocket medical expenses, but for most people, it's a fake promise. Yes, in computing your taxable income, there's a deduction for out-of-pocket medical expenses and health insurance premiums. But most people don't actually take that deduction, because they don't "itemize" their deductions – a long, crazy story for another day – and nonitemizers don't get the write-off. There are fewer itemizers at the moment than at any time in recent memory.

And even if you do itemize, you get to deduct only your out-of-pocket medical costs that exceed a certain percentage of your income. So if you have a healthy year and your health insurance isn't too speedy, you don't qualify for the deduction even if you do itemize.

If you don't get the deduction, your out-of-pocket medical costs are on you. You pay them with after-tax dollars.

Sounds kinda rough, but Congress has provided an escape hatch for people who are employed by progressive outfits that pay some or all of their employees' health care costs. Congress really likes it when your employer pays for your health care. And so when your employer does that, with rare exception, you don't have to report the benefit as income. It never shows up on your tax return. No matter how much it is, no matter how sick you get, no matter how much or how little you make. And that goes for any health care that your employer buys for your dependents, too.

Nowadays there probably aren't too many employers who pay the whole freight for their employees' health care. I'm sure the more typical scenario is that the employer pays some, or none, of the worker's medical expenses and premiums, and the employee pays some, or all. Anything the employer chips in is tax-free, but as I just did my best to explain, when the employee spends, it is usually after the IRS takes a bite out of the money.

If you're still with me so far, and an oxygen mask has not appeared, here is where the tax part really gets weird. And this is the part that has me up late at night shuffling papers around. So buckle up.

Congress decided to bend various rules so that employees can designate part of their salary toward medical care, and everybody will act, for tax purposes, like the employer paid for it. The tax code calls it a "cafeteria plan," but it has nothing to do with food, and I've never heard an employer call it that. It's usually presented to the employees as a "flexible spending" or "personal choice" account, or some such focus-group-tested name. If the employee elects to divert some salary into such an account to pay their share of health insurance premiums, the money that goes in there isn't taxable to the employee. The employee doesn't need the elusive deduction outlined earlier; the money placed in the account is never income to begin with. (A similar trick works with day care, but let's stick with medical for today.)

The same thing holds true for money that goes into such an account and is used to cover the employees' out-of-pocket expenses beyond health insurance premims. Most people are familiar with "co-pays," "co-insurance," and the like. If you run those annoying dingers through a "personal choice" account, the employee isn't taxed on them. Whereas if the employee just pays, without the magic account, then as seen earlier, the IRS usually gets a piece first. 

There's a limit to how much money you can run through a "cafeteria" account for out-of-pocket expenses beyond health insurance premiums. This year I believe it's $2,750. But if your federal and state tax bite is 30 percent, that saves the employee $825 for the year, just on the "co-pays." That buys a pretty nice phone. Not to mention 30 percent of many hundreds of dollars more on the employee's share of health insurance premiums.

Okay, I hope you're still with me. So the original idea of the workplace tax benefit was to encourage employers to pay for health care for employees and their families, but now the concept has been stretched to guarantee tax-free treatment even for the amounts the employee has to pay out of his or her own pocket.

I'm not sure that makes sense as a policy matter, but even if it does, what does it mean, on the ground? Endless paperwork and rigmarole.

Take me as an example. Every month, several hundred bucks comes out of my paycheck and goes into a "flexible spending" account with some sort of entity, I think it's a trust. It's a heavily regulated entity that has to comply with all sorts of federal laws and regulations, as you might imagine. The money that pays my share of health insurance premiums for me and the fam then comes out of that entity and goes to the insurance company.

Then when I pay for meds and doctor co-pays, I have to keep all my receipts and insurance benefit statements and file them with the trust to get reimbursed. This part of the setup is run by a nice company – in Missoula, Montana, of all places, shout out to Missoula, go Griz – and they have a website where I have to upload scans of the pharmacy receipts and insurance company explanations of what I paid out of pocket. If the paperwork is in order, they pay me. The Missoulans are quite efficient, and I get my money in a few days. But it comes in dribs and drabs. I may file with them six times a year.

It's all to beat the taxes. If it weren't for the tax rules, none of my money would go to Missoula. There wouldn't be a trust – at least, not the kind of trust we're talking about here. I'd just pay my doctor or the drug store what I owe, and be done with it. I would not be sitting up scanning papers and zapping them to Missoula to get them to put my money into my checking account, which is where it should have gone in the first place.

But this is America, and that is what we do.

Whatever you might think of the U.S. health care establishment, it's pretty clear to me that no one, and I mean no one at all, should have to pay tax on the money that they shell out for health care. The current, convoluted tax treatment of medical expenses, like the whole sorry state of the income tax, is more than a little embarrassing.

Not to mention bad for the environment. The amount of energy being used to scan and upload all those CVS receipts is enough to light a small village in Kyrgyzstan.