Tax Implications of the Affordable Care Act
The affordable care act is complicated. It’s a huge benefit to anyone trying to make it outside of the employment-based health care system, but it has drawbacks. One is that it creates a more complicated situation when it comes to evaluating how additional income will be taxed.
Meet your new marginal tax rates
But wait! The Affordable Care Act isn’t a tax, it provides subsidies!
This is a distinction without a difference. The affordable care act offers a subsidy that is phased out as your income gets higher. Higher income = less subsidy. You could just as easily write this equation as higher income = lower income tax credit/deduction. The US government has decided to separate the subsidy from the rest of your income taxes in a clever slight of hand, but you should not be fooled. For all meaningful purposes, the US government is just giving us another deduction/tax credit that phases out as income increases. Yes, it is tied to health insurance. But since it’s dumb not to get health insurance it will affect the NET amount that you pay the government every year if you purchase insurance on your own. And that amount will vary with your income. Hence income tax. So with that, I present your new marginal tax rates.
That is a weird picture! The affordable care act creates a number of strange effects when it comes to how your subsidy and plan benefits change as your income increases. I’ll point out a few of salient features.
The MASSIVE spike – Complete Phaseout at 400% FPL
See the massive spike up to a 700% marginal tax rate? Technically this could be a near infinite rate depending on the cost of the health plans in your state and how granular of income changes you want to examine.
At around $88k our family of 3 crosses over 400% of the federal poverty line and loses all premium subsidies. In our model, those subsidies are still worth around $3500 at that point. $1 of extra income could push them over that threshold and cause all of the subsidies to evaporate. A marginal tax rate near infinity for that last $1. The severity of the tax is entirely dependent on the price of the health plans on your exchange. Higher priced plans = higher spike in costs when you cross the 400% threshold and lose your subsidy.
Takeaway: Be VERY careful of your income near this threshold. For our family of three, that is $80640. If your income is approaching this level keep it under the cap.
The Other Large Spikes – Changes in Silver Plan Cost Sharing Subsidies
These spikes are only applicable if you purchase a silver plan and utilize a significant amount of healthcare in the year. Cost-sharing subsidies available to those with income below 250% of the FPL purchasing Silver Plans. The difference in cost sharing between income tiers can be significant – several thousand dollars in reduced deductibles, coinsurance, or out of pocket maximums.
I’ve modeled this by making assumptions about the amount of care needed and changes in deductibles for silver plans. But how exactly these changes will manifest vary significantly depending on the unique circumstances of your local state marketplace. Insurers have broad latitude in how they can adjust the deductibles, max-out-of-pocket costs, and copays/coinsurance in order to meet the percentage targets.
Takeaway – For those utilizing large amounts of care and utilizing Silver plans, 3 additional spikes are introduced at 150%, 200% and, 250%. Or around $30k, $40k, and $50k for our family of three. These spikes will vary in size based on the unique conditions in your marketplace and your health.
The Spike Far to the Left – Rapid change in subsidy amount
At 133% of the FPL, or about $26.8k for our family of three, the maximum % of your income you are expected to pay in premiums jumps from 2% to 3%. This results in a reduction in subsidies of almost $300 for crossing this point.
Takeaway – for those with very low incomes, this is a VERY steep marginal rate, one usually only seen with those making $400k+. If your income is going to come in at this point at the end of the year it may be worth reducing hours to make sure you are under this cap.
Flat Areas – Normal Subsidy phaseout as income increases
There are some relatively flat areas, ranging from 9-20% below 300% FPL and 10% from 300-400%. These simply reflect the gradual phaseout of subsidies as your income increases. Conceptually, this subsidy reduction adds an additional marginal tax rate onto your existing income tax (10-15% in this range). Essentially every additional dollar in income you earn in this range is getting taxed between 25-30%.
Takeaway – The Affordable Care Act introduces marginal rates for those below 400% of the poverty line near the ranges at much higher incomes. Marginal rates for low incomes are now between 25-30%.
Impact on Capital Gains/Dividends
This is another point that is important to consider, especially for early retirees who will be living off of investments. Within the 10-15% tax bracket, qualified dividends and long-term capital gains are normally taxed at 0%. This is now no longer the case. Because dividends and capital gains are included in your AGI and AGI is used to calculate subsidies, recognizing any capital gain or dividend will trigger a subsidy decrease. This creates a 10-20% marginal tax on capital gains and dividends while receiving subsidies.
How to manage income
I’ve listed a number of pitfalls that could potentially cause massive drops in subsidies/spikes in tax bill if you cross certain income thresholds. Let’s talk about a few potential ways to manage around those cliffs. Unfortunately, because the subsidies are based on AGI most of the income tax management techniques are not available. AGI comes before most standard deductions. So what can you do?
- Tax-deferred Accounts – This is the easiest line item to manipulate. By using 401ks, IRAs, or HSAs you can bring your income down below critical thresholds
- Capital losses – if you have investments in taxable accounts you can realize losses at strategic times to bring your income in at a certain threshold. However, since you should be harvesting capital losses on a regular basis anyway this has somewhat limited applicability
- Depreciation and expenses for Investment Real-estate – A more advanced topic for a later day, but you can potentially use investment properties to manage your final AGI
- There are now multiple spikes in effective marginal tax rates at certain income levels as a result of the Affordable Care Act. These occur at 133%, 150%, 200%, 250%, and 400% of the Federal Poverty Line for your area
- The Affordable Care Act essentially creates an additional effective marginal tax on any income below 400% of the federal poverty line. Increased income = reduced subsidies.
- There is now an effective 10-20% marginal tax rate on long-term capital gains and qualified dividends for those under 400% of the FPL who buy insurance in the marketplaces.
- You can find all of the calculations over in our tools and research.