Pay and Benefits Watch: Health and taxes

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Should you let Uncle Sam convert your health premiums to non-taxable income in October? For most federal workers, the answer is yes. But for a handful of employees, it would be better to let the government tax their health premiums. (For background on the upcoming switch making federal employees' health premiums non-taxable, see "Health premiums and retirement," March 9.)

Taking health premiums out of your taxable income will lower your Social Security retirement benefits. For most people, the benefits of having more take-home pay now outweigh the benefits of slightly larger Social Security retirement benefits.

Let's get out our calculators and see how the switch to non-taxable premiums will affect your Social Security benefits (this applies to Federal Employee Retirement System enrollees, not Civil Service Retirement System enrollees, who do not participate in Social Security).

Follow these steps, which are accompanied by the description of an example employee.

  1. Determine how much you pay in health premiums each year. In our example, we'll assume the employee belongs to Blue Cross and Blue Shield's standard family option, in which he pays about $1,700 a year.
  2. Calculate 35 percent of your annual health premiums. That's the standard combined rate of federal, local, Social Security and Medicare taxes. This figure is how much extra you would take home each year thanks to the conversion of health premiums to non-taxable income. In our example, the employee's take-home pay goes up $595 a year, or $50 a month.
  3. Look at your current taxable income and figure out what your taxable income would be if you converted your premium. Our example employee earns $50,000 a year now. His taxable income would be reduced by $1,700, to $48,300.
  4. Use this calculator provided by the Social Security Administration to compare your Social Security benefits if you remained at your current taxable income and your benefits if you reduced your taxable income by the amount of your health premium. Assuming, for simplicity, that our example employee has made $50,000 a year his entire working career, his monthly Social Security benefit would be reduced by $15.60 if he converted to non-taxable health premiums.

    In our example case, it's clearly in the employee's interest to take the non-taxable health benefit, because he'll get $50 extra a month now, as opposed to $15.60 a month when he's retired.

    Tammy Flanagan, senior benefits director with the Fairfax Station, Va.-based National Institute of Transition Planning, suggests that people invest that extra pocket money each month, and "you will not have to worry about Social Security in the future."

    "My vote is to participate in premium conversion," Flanagan said. The exception, she said, would be for employees who are in very low wage jobs, where the loss of Social Security benefits would be more significant than for higher-paid workers.

    The Office of Personnel Management is working with agencies to prepare payroll systems for the change, which will be automatic for all employees. You won't have to do anything to take advantage of the new tax-free benefit. But if you don't want to take advantage of it, you'll have to get a waiver form from your agency's personnel office.

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