Friday, November 29, 2013

Weird Obamacare Incentives and Strategies - 4

This is the fourth (and possibly last) in a series of posts that have me a bit conflicted.  They could be interpreted as political, and, as advice, some of it may be considered unethical, but the point of the posts is to point out things in the law that provide negative incentives, and, at the same time, point out actions that can have big negative consequences on someone receiving a Premium Tax Credit (hereafter referred to as a subsidy.)  They are primarily designed to ensure that people don't make huge mistakes with huge consequences.  They should not be interpreted as me suggesting that you manipulate the rules in any illegal or unethical way.  If you continue reading these posts you will understand what I mean.  

This one's more than that.  It's really a post about how the Affordable Care Act raises the bar on the already extensive incentives for not reporting all income received.  Many would call this cheating, and it is.  But most people have a moral continuum on cheating (I can't, in my capacity as a tax guy, have this continuum, but, as an individual, I don't have to condemn someone for manipulating the system - though I can't help.)

As an example, most people would be understanding of waitstaff who don't report all their cash tips to their employer.  Anyone who knows someone in this industry understands how common this is.  It results in some tax savings, but robs them of some credit to Social Security.  In some situations (such as with Earned Income Credit (EIC)) people might be surprised how dramatic the savings can be - and might find themselves less sympathetic - but that's not the point of this post.

I think most people don't lose sleep over the contractor who receives the majority of their income in a format that is reported to the IRS, but doesn't report the occasional "under the table" transaction.  The sympathy would drop if the contractor encouraged cash payments with a discount in order to avoid taxes, and I think would disappear altogether for one who earns all of their income, especially if it's substantial "under the table."

To be clear, all of the above is black and white under the law.  It is cheating, and, if the IRS finds out, they will come after you, and there will be very little sympathy.  Also, if I'm your tax guy, I will report all income you receive that I know about, and I will ask about, and document your answers if there is indication of unreported income (especially if EIC is involved.)  I am required to do this - and I take my job seriously - since doing so protects you as well as me.

The Affordable Care Act changes all this.  Now, the waiter who fails to report his tip income is not only cheating on his taxes in a common, if illegal, way, he is now defrauding the government of health care benefits by receiving a subsidy for insurance in excess of what he is entitled to.  The tax return is the entry point for a subsidy, and is the final calculation to determine any rebate or repayment.  Even worse, since the exchanges are now a pathway to Medicare, many people in this situation could end up receiving Medicare and other government benefits they don't deserve.  The contractors described above can face even worse moral dilemmas, though we may not be as sympathetic to some.

It's possible to dismiss all of this and say, honesty is the best policy, and have no sympathy for the cheaters, and there's some truth to that.  My problem with that attitude is that when you take the system overall, coupled with the mandate to get insurance, many people will be faced with impossible choices.  If they decide to turn over a new leaf, and be honest about all their income, and also follow the law and obtain health insurance, they could face an enormous change in economic circumstances:

Imagine a waiter or waitress with two children and a reported income of $24,000 but actual income of $32,000, that has only been reporting the $24,000.  With absolutely no withholding other than mandatory social security and medicare, he/she would be getting a tax refund of $6004 and would be eligible for Medicaid.*  Claiming all income would result in a tax change of $3547 (mostly at the return, though $612 would be withheld from paychecks to cover Social Security and Medicare).  He/She would also now have to pay at least $48 per month for MINIMUM coverage for their family.  Resulting in a net change in disposable income of $4123 per year or $344 per month.  Put yourself in their shoes and try to make that choice.  Before you say, "But now they have medical insurance!", remember that they were eligible for FREE healthcare before reporting their additional income.

Here are numbers for our family at various income levels.  The one thing not included here is that, in addition to paying or receiving the taxes and insurance discussed in the list, their will be an increase in withholding equal to 7.65% of the unreported income.  This means that if you want to calculate the net effect of a reporting difference between two incomes, you have to multiply the difference in income by 7.65% and add it to the increase.  I assume no withholding other than Social Security and Medicare, so everything is settled on the tax return.  I include a range of numbers for insurance from crappiest to best available insurance.

Income of $24,000 gets refund of $6004 and pays nothing for health insurance
Income of $28,000 gets refund of $4312 and pays nothing for health insurance
Income of $32,000 gets refund of $3069 and pays $576 to $1260 for health insurance annually
Income of $35,000 gets refund of $2001 and pays $960 to $1656 for health insurance annually
Income of $40,000 gets refund of $157 and pays $1680 to $2364 for health insurance annually
Income of $45,000 pays a tax bill $1187 and pays $2388 to $3084 for health insurance annually

Using that list you can calculate the "cost" of claiming all reported income by comparing the change in taxes and insurance, and adding 0.0765 times the difference in income to the difference in taxes and insurance.  For example, in my $24,000 to $32,000 calculation, I subtracted $3069 from $6004 to get $2935 tax difference, subtracted 0 from $576 to get $576 health insurance difference, and multiplied $8000 (32,000-24,000) by 0.0765 to get $612 Social Security/Medicaid withholding difference.  This gave me a grand total of $4123.

For contractors it's even worse.  Instead of 0.0765, you multiply the difference by 0.153 since they pay the employer's portion of Social Security and Medicare too.

The cynical person would call the resulting numbers the amount by which the taxpayer defrauded the government, another person might call it the price of honesty.  I think we can all understand why some people do it, and the difficult decision someone with limited income can face when it comes to taxes.  That decision is made worse by the Affordable Care Act.  It's not my place here to say if the benefits outweigh the costs, but this is a cost that few people have considered.

If you are in this situation, I feel for you, but I hope this post helps you plan ahead and be prepared for what may happen.  I'm happy to help you with this, but be aware that if I file your taxes, I'll expect honesty.

*I used 2013 tax numbers and Rhode Island State Health Exchange since they have the best tools for estimating healthcare costs.  The tax numbers may be a bit off since I was winging it with a calculator, but their close.

Previous Obamacare Incentive Posts:

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