Since the program became effective in October 2000, federal employees have been paying their portion of the Federal Employees Health Benefits (FEHB) program premiums – on average 25 to 28 percent of the total FEHB premiums – using before-taxed (gross) salary dollars. This program, called “premium conversion”, has resulted in thousands of tax dollar savings for federal employees. This column discusses the advantages and disadvantages of “premium conversion”.

Premium conversion is a before-tax arrangement meaning that a part of an employee’s salary is used to pay the employee’s FEHB program insurance premiums and is nontaxable to the employee. Nontaxable means that the portion of the gross salary that is used to pay the premiums is not subject to federal income tax, Social Security (FICA) tax equal to 6.2 percent of wages, and Medicare Part A (hospital insurance) payroll tax equal to 1.45 percent of an employee’s wages. In most states with a state income tax, the employee will also save on state and local income taxes. The federal government also benefits from premium conversion because for the portion of the gross salary not subject to FICA and Medicare Hospital insurance payroll taxes, the employee’s agency does not have to match those contributions.

With respect to the amount of total tax savings resulting from premium conversion, the answer depends on the employee’s overall tax bracket. Suppose an employee is in a combined 40 percent tax bracket (federal and state income tax combined 33 tax bracket, Social Security and Medicare Part A payroll taxes totaling 7.65 percent). If the employee pays each month $500 in FEHB premiums, then the employee is saving each month approximately 40 percent (25 percent plus 8 percent plus 7.65 percent) of $500, or $200 in total taxes through participation in premium conversion. These tax savings will accumulate over the years.

Note that only employees can participate in premium conversion. Annuitants cannot participate in premium conversion. Annuitants always have their FEHB premiums deducted from their after-taxed CSRS or FERS annuities.

The following worksheet can be used to estimate an employee’s annual tax savings:

Premium Conversion Financial Worksheet

Use Part One and Part Two of the worksheet to estimate your annual tax savings with premium conversion, and use Part Three of the worksheet to estimate the effect of premium conversion on Social Security retirement benefits.

Part One: Determine taxable salary

 

  1. Enter your current annual salary.                        $_________________
  2. Enter your annual FEHB premium payment (biweekly premium

payment multiplied by 26)                                     $_________________

  1. Subtract Line #2 from Line #1.This is your taxable salary resulting from

premium conversion.                                              $_________________

Part Two: Compute tax savings

  1. Enter your annual FEHB premium payment (as entered in

Part One, Line #2)                                                    $_________________

  1. Enter the sum of:

(a) Your Federal income tax bracket (0.10, 0.15, 0.25, 0.28, etc.) and

(b) Social Security tax (0.062) if applicable to you, and

(c) Medicare tax (0.0145)                                              x _________________

  1. Multiply #1 by #2. This is an estimate of the annual amount of tax

you avoid with premium conversion.                        $__________________

 Note: Additional savings on State and local income taxes, if any, are not included for the purpose of simplifying this estimate.

The following example illustrates the use of Part One and Part Two of the worksheet:

Annual Salary = $100,000

Annual FEHB Premium Payment = $4,000

Federal income tax bracket = 25%

Social Security (FICA) tax = 6.2%

Medicare Part A (Hospital) insurance tax = 1.45%

Part One: Taxable salary

  1. Enter your current annual salary.                        $100,000
  2. Enter your annual FEHB premium payment (biweekly premium

payment multiplied by 26)                                     –   $4,000

  1. Subtract #2 from #1. This is your taxable salary with

premium conversion.                                                 $96,000

Part Two: Tax savings

                                                                          

  1. Enter your annual FEHB premium payment (as entered in

Part One, Line #2)                                                      $4,000

  1. Enter the sum of:

(a) Your Federal income tax bracket – 0.25, and                                          x   .3265

(b) Social Security tax (0.062), if applicable to you, and                    (.25 + .062 + .0145)

(c) Medicare tax (0.0145)

  1. Multiply #1 by #2. This is an estimate of the annual amount of tax     

you avoid with premium conversion.                                                    $1,306

Is there any disadvantage with respect to premium conversion? The only disadvantage may be the small reduction in future Social Security benefits. But the increase in take-home pay resulting from reduced taxes far exceeds what should amount to be a small reduction in future Social Security benefits.

Part Three of the worksheet can be used to estimate the annual loss in future Social Security benefits using today’s dollars. In order to complete this part of the worksheet, one must have access to the Social Security Web site at www.socialsecurity.gov and using the instructions below.

  1. Using the instructions entitled below “Using the SSA Web Site Calculator”,

enter your estimated monthly Social Security benefit at

retirement (Step 5) WITHOUT premium conversion.                                                        $_____________

  1. Use the instruction entitled “Using the SSA Web Site Calculator”,

enter your estimated monthly Social Security benefit at

(Step 7) WITH premium conversion.                                                                         – $_____________

  1. Subtract #2 from #1. This is the difference in monthly Social

  Security retirement benefits.                                                                                           $_____________

  1. Multiply #3 by 12                                                                                                                      x 12
  2. This is the estimated annual Social Security benefit increase

over a 35-year career by waiving premium conversion.                                              $_____________

  1. Divide by 35                                                                                                                             ÷ 35
  2. This is the estimated Social Security benefit you earn for each

year you waive premium conversion.                                                                          $_____________

  1. Enter the annual amount of tax you save with premium

conversion from Part Two, #3.                                                                                     $_____________

  1. Divide the amount in #8 by the amount in #7. This estimates

   how many years of Social Security retirement benefits are

   needed to make up for the additional taxes you paid by not

   participating in premium conversion.  Because most people

   receive Social Security for about 20 years, you may want to

   consider waiving premium conversion if this number is less than 20                         _____________

Note: when you reduce your taxable salary by your annual health benefits premium in the SSA benefit calculator, the model assumes a different salary over your entire career (35 years for Social Security benefit calculation purposes.).

Using the SSA Web Site Calculator to Complete Part Three:

Step 1. Go to www.ssa.gov/retire .

Step 2. Click on the first box in the left hand column menu labeled “Calculators”.

Step 3. A new screen will appear with three boxes on the right hand side. Click on the box “Quick Calculator”.

Step 4. Follow the instructions on how to use the calculator. You will need to use this calculator twice

(Steps 5 and 7).

Step 5. Enter your age, current salary and select the “Today’s Dollars” option in the menu list for the third time on the calculator. Click on “Submit Request” and a calculation will appear. Enter the figure for your estimated monthly Social Security benefit in Part Three, Line #1.

Step 6. Use the “Back” button on your browser to return to the calculator.

Step 7. Enter your age, salary with premium conversion (Part One, Line #3), and select the “Today’s Dollars” option in the menu list for the third item on the calculator. Click on “Submit Request” and a calculation will appear. Enter the figure for your estimated monthly Social Security benefit in Part Three, Line #2.

The following example illustrates the use of the worksheet for Part #, using the above information.

Annual Salary = $100,000

Annual FEHB Premium Payment = $4,000

Federal income tax bracket = 28%

Social Security (FICA) tax = 6.2%

Medicare Part A (Hospital Insurance) tax = 1.45%

Age of Employee = 25

Full Retirement Age = 67

  1. Using the instructions entitle “Using the SSA Web Site Calculator”.

Enter your estimated monthly Social Security benefit at

retirement (Step 5) WITHOUT premium conversion.                                                $2,623

  1. Use the instruction entitled “Using the SSA Web Site Calculator”.

Enter your estimated monthly Social Security benefit at

(Step 7) WITH premium conversion.                                                                         – $2,573

  1. Subtract #2 from #1. This is the difference in monthly Social

Security retirement benefits by waiving premium conversion.                                      $50

  1. Multiply #3 by 12                                                                                                          x 12
  2. This is the estimated annual Social Security benefit increase

over a 35-year career.                                                                                                  $600

  1. Divide by 35                                                                                                                  ÷ 35
  2. This is the estimated Social Security benefit you earn for each

year you waive premium conversion.                                                                             $17

  1. Enter the annual amount of tax you save with premium

conversion from Part Two, #3.                                                                                    $1,306

  1. Divide the amount in #8 by the amount in #7. This estimates

how many years of Social Security retirement benefits are

needed to make up for the additional taxes you paid by not

participating in premium conversion.  Because most people

   receive Social Security for about 20 years, you may want to

   consider waiving premium conversion if this number is less than 20.                         =     77

Some additional items that federal employees should know about premium conversion

  1. Participation in premium conversion can affect when an employee can make changes to their FEHB program enrollment.  Enrollment changes may only be made outside of the FEHB open season under certain circumstances. Under premium conversion, the opportunity to reduce or cancel one’s FEHB program enrollment may be limited by the Internal Revenue Code. An employee will be allowed to drop coverage or change to “self only” coverage outside of “open season” only if the employee’s decision to do so comes at the time of a qualifying life event. An employee who is not participating in premium conversion may elect to reduce their FEHB program coverage at any time. But an employee who is a participant in premium conversion will be able to reduce FEHB program coverage only during a FEHB program “open season” or in conjunction with a qualifying life event (QLE). IRS rules govern these non-open season opportunities for those employees who participate in premium conversion.
  2. Employees who participate in premium conversion cannot include FEHB program premiums they pay as part of their out-of-pocket medical, dental and vision expenses when determining how much of these expenses can be deducted as qualifying itemized deductions on Federal Schedule A as “medical and dental” expenses. These expenses in excess of 10 percent of the employee’s adjusted gross income (AGI) will be potentially deductible.

Employees have the option of opting out of premium conversion with respect to the FEHB program. As discussed above, for most employees it makes sense to participate in premium conversion. But for those employees who expect a large amount of out-of-pocket medical expenses during 2017 including FEHB premiums, opting out of premium conversion may make financial sense in terms of overall tax savings. These employees can re-enroll in premium conversion for 2018 during the 2017 FEHB program’s “open season” if they expect fewer out-of-pocket medical, dental and vision expenses during 2018.

Employees who choose to not participate in premium conversion may do so during the “open season” by filling out and submitting a waiver form to their payroll/personnel staff. This same waiver form is used to restore participation in premium conversion and is also filled out during the annual FEHB program “open season”.

It should also be noted that employees can enroll in separate dental and vision insurance for 2017. Dental and vision insurance is offered through the Federal Employee Dental and Vision Insurance Program (FEDVIP). Premiums are paid entirely by employees with no Federal government contribution. Unlike the FEHB program, employee-paid premiums in the FEDVIP are always deducted from employees’ gross salaries. Employees have no option of opting out of premium conversion through the FEDVIP. Information about the FEDVIP may be obtained at Dental Vision Page.