How to save your income

Each year during the federal benefits open season, employees and annuitants make decisions regarding which health, dental and vision insurance plan they want to be covered by during the upcoming plan year that starts in early January. Federal employees also have to decide whether they want to enroll, or to re-enroll, in a health care flexible spending account (HCFSA) or a limited expense flexible spending account (LEXFSA), and a dependent care flexible spending account (DCFSA) for the new plan year. This column discusses “premium conversion” — the first of a series of columns discussing the choices that employees and annuitants must make during this year’s open season (November 13 through December 11, 2017).

What is Premium Conversion?

Premium conversion is an arrangement in which federal employees — but not annuitants — pay their health, dental and vision insurance premiums with “before-taxed” salary dollars. “Before taxed” salary means before all taxes – this includes federal and state income taxes, Social Security (FICA) and Medicare Part A (hospital insurance) payroll taxes are deducted from the employee’s gross salary to pay the health, dental and vision insurance premiums due each pay date. The following example illustrates:

Caroline is enrolled in the Federal Employees Health Benefits (FEHB) program, self and family coverage, and pays $500 in premiums each pay date for her FEHB health insurance plan. The $500 is deducted from Caroline’s salary to pay the premium due. Assuming she is in a 25 percent federal tax bracket and 8 percent state income tax bracket, Caroline pays the following amount in total taxes by having the full $500 deducted from her gross salary to pay the premium due:

25 percent (federal tax bracket) plus 8 percent (state tax bracket) plus 6.2 percent (FICA payroll tax)          

 plus 1.45 percent (Medicare Part A payroll tax)

equals 40.65 percent

 40.65 percent of $500 equals $232.50

Over 26 pay dates (one year) Caroline is saving over $6,035 in total taxes through participation in “premium conversion”.

Note that none of the FEHB insurance premiums deducted under premium conversion are subject to either income (federal and state) or payroll (Social Security –FICA and Medicare Part A-hospital insurance) taxes. This is somewhat different than traditional Thrift Savings Plan (TSP) contributions in which the employee’s contributions are deducted from the employee’s gross salary – before federal and state income taxes – but after Social Security and Medicare Part A payroll taxes are withheld, and the employee pays federal and state income taxes upon withdrawing the TSP account.

Employees who enroll in the FEHB program and in the dental and/or vision insurance offered through the Federal Employees Dental and Vision Insurance Program (FEDVIP) are automatically enrolled in premium conversion. Under IRS rules, annuitants are not allowed to participate in premium conversion. Annuitants who are enrolled in the FEHB program and FEDVIP by law must have their premiums deducted from their after-taxed annuities. Their CSRS and FERS annuities are not subject to FICA and Medicare part A payroll taxes and, in several states, not subject to state and local income taxes.

When Should You Waive Premium Conversion?

Federal employees have the option of waiving premium conversion with respect to their FEHB program premiums. They do not have the option of waiving premium conversion with respect to their dental and vision insurance premiums under the FEDVIP. The question then becomes : Why would an employee want to waive premium conversion and forgo the associated tax savings? Possible reasons include: (1) Flexibility; and (2) Effect on future Social Security retirement benefits. These reasons are now discussed.

Flexibility

An employee participating in premium conversion generally has all the same flexibility as an employee who chooses not to participate. But tax laws give two exceptions. If an employee waives premium conversion, then the employee will have the flexibility to either drop his or her FEHB insurance altogether or change from Self and Family or Self plus One enrollment to Self Only enrollment at any time of the year without giving any reason. An employee who participates in premium conversion will be allowed to drop FEHB coverage, or to change to Self Only coverage only during an open season or if the employee experiences a qualifying life event such as marriage or the employee’s spouse has a job in which the spouse enrolls in the job’s group health insurance plan. But this flexibility is generally of little or no value compared to the tax savings associated with premium conversion.

The other reason that an employee may want to waive premium conversion is that FEHB program premiums an employee pays with before-taxed salary dollars under premium conversion cannot include those premiums as qualifying medical expense on Schedule A (Itemized Deductions) on the employee’s federal income tax return. However, to be able to deduct qualifying out-of-pocket medical expenses, an individual’s total medical, dental and vision expenses would have to exceed 10 percent of the individual’s adjusted gross income (AGI) in that year. If an employee adds up all of his or her expenses-  out-of-pocket medical, dental and vision expenses, including FEHB premiums, and the total exceeds 10 percent of the employee’s AGI for the upcoming year, then waiving “premium conversion” may result in greater federal and state income tax savings compared to the tax savings associated with “premium conversion”. As a “heads-up” for those employees who are considering waiving “premium conversion” for 2018 during the current “open season”, the federal income tax overhaul plan currently being considered and debated in Congress would get rid of the medical expense deduction. In that case, waiving “premium conversions” for any additional tax savings would not apply.

Effect on future Social Security benefits

As previously mentioned, premium conversion means paying one’s FEHB health insurance and FEDVIP dental and vision premiums with “before-taxed” dollars, including FICA (Social Security). Each year, an employer reports employee Social Security wages (as shown on the employee’s W2) to the Social Security Administration. Participation in “premium conversion” therefore results in lower Social Security wages for a participating employee. Since the Social Security Administration determines an individual’s future Social Security retirement benefits based on the individual’s 35 highest years of Social Security earnings, participating in “premium conversion” could result in a slightly lower Social Security retirement benefit when the individual files for that benefit. The extent of benefit reduction will depend on: (1) The employee’s retirement system. CSRS and CSRS-Offset employees need not be concerned while FERS –covered employees who do pay into Social Security are affected; (2) the employee’s salary compared with the Social Security maximum wage base ($127,200 during 2017 and $128,700 during 2018); and (3) the number of years the employee has until retirement.

How Is Premium Conversion is Waived?

During the FEHB open season, employees have the opportunity to elect or waive their participation in premium conversion. An open season election to participate or waive participation in premium conversion must be received by an employee’s employing agency no later than the last day of the “open season”. The effective date of the elective is the same as the effective date of a FEHB election which is the first payroll period that begins on or after January 1st.

This year’s open season dates are from Nov. 13, 2017 through Dec. 11, 2017. The start of the first payroll on or after Jan. 1, 2018 is Jan. 7, 2018. This means that employees who wish to enroll or waive participation in premium conversion must do so no later than close of business on Dec. 11, 2017, with an effective date of Jan. 7, 2018.

Federal employees should consult with their personnel or human resources office for the necessary paperwork and forms required to elect or to waive premium conversion during the open season.

A table of permissible changes in FEHB enrollment and premium conversion election may be downloaded here.