Today on Radical Personal Finance, we continue our health insurance series by tackling a technical financial planning topic. Today we discuss the premium tax credit. I intend to do it in a fairly detailed way, explain to you what it is, how it works, and how it can benefit you. This topic is one that can make a huge difference to your finances if you are in the low to middle income classification of income levels.

This is the tax credit that was enacted as a component of the Affordable Care Act, where it was put in place to help low and middle income people be able to afford health insurance, and its potential benefits are substantial. Welcome to Radical Personal Finance, the show dedicated to providing you with the knowledge, skills, insight, and encouragement you need to live a rich and meaningful life now while building a plan for financial freedom in 10 years or less.

My name is Joshua Sheets, and I am your host. Today we tackle this premium tax credit. This is a fun one, and it's a potentially very large one, somewhat simple, somewhat complex. Today I'm going to give you enough of an overview that I think you'll feel confident approaching this subject for yourself.

If you think back to how the Affordable Care Act was enacted, there were a couple of things that were going into play. Number one is that one of the major goals of legislators was to pass a law that would enable, that would reduce the number of uninsured people, basically.

That was one of the fundamental goals. The idea was that health expenses are too high, doctor bills are too high, and so everybody needs some form of health insurance coverage. There are a few ways of skinning this cat. Number one way was to require everybody to own health insurance.

That was one component of it. But in order to require everyone to own health insurance, they had to figure out a way to be able to make that financially feasible for people who don't otherwise own health insurance. There were two aspects to that. Number one is they had to remove the ability of the insurance companies to screen people based upon criteria that they would find acceptable, to screen people based upon preexisting conditions, et cetera.

Number two is they had to figure out a way to help people to pay for it, to help people to pay for the insurance coverage that was going to be provided for them. It was decided to do that through the primary use of a premium assistance tax credit. That was how the financial component was to be addressed.

The way that coverage was going to be offered to all was to set up either a state or a federally run health insurance exchange where health insurance policies are open to everybody during the normal enrollment periods, but they're open to everybody without any screening of medical preexisting conditions, et cetera.

Now for those of you in the early retirement financial independence space, these couple of things joined together create a tremendous opportunity for you. See when they limited the medical requirements to be able to obtain health insurance, that made it far easier for people like you and me to disconnect our health insurance coverage from our job without the fear of not being able to get good coverage in the future.

Now if you had coverage, this was always possible before the Affordable Care Act. For example, if I had previously been working in a job that provided health insurance, I could transition to another job that provided health insurance and as long as I didn't lapse my coverage, my preexisting conditions would still be covered.

I could even do this to some extent in the individual health insurance marketplace as well, but I had to maintain that continuity of coverage. The challenge would be, well, what if I dropped my coverage? How do I get coverage again? Well, if you dropped your coverage under the system of preexisting conditions, you would have to have a waiting period even when enrolling sometimes in a group plan or you would be declined coverage completely if you were going to enroll in some sort of individual health insurance policy.

That made things difficult for people who had preexisting conditions. Now it made the insurance marketplace work relatively effectively. See if an insurance company is not able to screen out risks, that means that they experience something that's called adverse selection. The idea here is that they know that people who are more likely to need the benefits from the policy will buy insurance and people who are healthier, who are less likely to need benefits from the policy will probably not buy the insurance.

The people who would love to buy life insurance are those who were just diagnosed with cancer. Those people would – man, if I could underwrite people that bought cancer and I had a life insurance company that would take them, I could stand outside a cancer ward and I could just do business all day long.

But of course, people who are just diagnosed with cancer generally can't get life insurance. It's too late. And so that's how an insurance company keeps their insurance business working based upon having actuarially sound database, having people that are representative of the general population. You can't expose a marketplace to adverse selection.

So that was the fear that insurance companies had was they can't expose their business to sick people because they know that sick people are much more likely to sign up for and purchase health insurance. So in order to require that, that was why those two things had to go together that the Affordable Care Act legislation promised was number one, everybody has to be covered and then number two, everybody has to purchase coverage or there's a penalty.

We'll deal with the penalties another day. But this has actually been one of the major influences that has led to the problems that the health insurance marketplace has experienced since the passage of the Affordable Care Act with the significant increases in premium. All of the sick people who previously couldn't get health insurance coverage quickly signed up for health insurance.

That adjusted the underlying premiums and as the premiums have increased, people who were healthy and who generally didn't need it, many of those people have opted to forego insurance completely. So that's led to some of the problems that we face today. But the fact that anybody can get health insurance regardless of health conditions, preexisting health conditions, is an incredible opportunity that you may be able to utilize or you may even be able to exploit.

For example, many in my audience are pursuing some kind of transition plan where they want to go and leave one job and take a time off, take a sabbatical. Or some in my audience have a desire to leave their job and retire completely. Well if you're under the age of 65 and don't have access to Medicare, previously that was difficult.

But today, you're good to go. I mean today, it's even better where even if you choose to not own health insurance at all and if you develop some kind of significant medical problem, you wouldn't be covered during that period of time. But at any point during the time that you have that problem until open enrollment were to open up for the federal and state health insurance exchanges.

But even if you didn't bother to buy health insurance, you could just simply step in and buy health insurance during the open enrollment period at the end of the year. And they can't exclude you because they can't exclude anybody with pre-existing conditions. So that was a major, major change in the health insurance business.

Time will tell what ends up happening. It has made a tremendous negative financial impact on the insurance companies in terms of their performance of their policies as I understand the news reports and things that I read. The hope was that by enrolling additional insureds, that negative financial impact would be made up and that's what's unclear at the moment.

And then with the election of Donald Trump as president with his promise to repeal and replace Obamacare, many things are unclear at the moment. So we're just going to deal with the law as it stands today and time will tell how long this information is helpful and accurate. But that covers the health side.

What about the financial side? Knowing that you can't require people to buy something and not make it financially affordable and also knowing that major risk of adverse selection for people who just say, "Well, I know I can just sign up anytime," those two things had to be solved with some kind of financial planning idea.

And so the idea that was launched and was passed was the premium tax credit. And so the idea here is that a large number of low and middle income people who are buying health insurance through the government exchanges are eligible for a premium tax credit. And this is a significant percentage of the population, especially when measured by income.

The first thing I want to talk about is eligibility. And here I'm going to go down through some questions that are on one of the IRS's flow chart for – it's called the premium tax credit flow chart. Are you eligible? And the very first most important question to ask is this.

Did you or a family member enroll in insurance through the marketplace, through healthcare.gov, through the marketplace? If no, then you are not eligible for the premium tax credit. That's the first thing. So if you are enrolled in an employer plan, if you do what I do and you're involved in a health sharing ministry organization, if you don't have health insurance or if you've enrolled in health insurance in some way other than through the marketplace at healthcare.gov, then you are not eligible for the premium tax credit.

So that's important. Next question. If yes, if you did enroll through the marketplace, we go to the next question. Are you and every member of your family eligible for coverage through an employer or government plan? Are you and every member of your family eligible for coverage through an employer or government plan?

If you are protected by a government plan or an employer plan, if the coverage has been offered to you, then – if the answer to that question is yes, meaning the coverage has been offered to you, then you are not eligible for the premium tax credit. So you can't – if any coverage – if the coverage that's – and we'll cover that in a little bit – has to be – meet certain standards for affordability.

But vast majority, if your employer is offering you health insurance coverage, you will not be able to get this premium tax credit. But if you're not offered coverage, we go on to the next question. Is your household income at least 100% but no more than 400% of the federal poverty line for your family size?

Now this is a chart which I can't reproduce in a verbal format for you. But the numbers for the federal poverty line level, these are updated every year and they do depend on household size. So as an example, the current – meaning the 100% federal poverty level for a household of one, you as an individual, is an annual income of $11,770.

So if you make at least $11,770, you have the opportunity to participate in this tax credit and you can earn up to four times that amount which would be $47,080 as a household of one and still be eligible for some amount of the premium tax credit. If you're below that 100% of the federal poverty level number, then you will not be eligible for this premium tax credit but you will be moving over into Medicaid eligibility.

So although you will not be eligible for the credit, you still aren't going to be paying much or anything for health insurance coverage. Now as the household size increases, these numbers increase. So for example, a household of four, husband, wife, two children, household of four, the federal poverty level for that household size is $24,250.

And 400% of that would go up to as high as $97,000. So if you're a family – let me just go through some household sizes here. Household size of one, the range is 11,770. I'm going to round these numbers. The range is 12,000 up to 47,000. Household size of two, the range is 16,000 up to $64,000.

Household size of three is 20,000 up to $80,000. Household size of four is 24,000 up to $97,000. Household size of five is 29,000 up to $113,000. Household size of six would be anywhere from $32,000 to $130,000. And it would go up from there. So those of you who have larger families, household size of eight would be up to $163,000 which is 400% of the federal poverty level for that size of household and you're still eligible for some amount of the premium tax credit.

For each additional child beyond there, there's an extra $4,000 on the bottom end and up to $16,000 on the top end. So you can calculate that beyond there if you have a large household. So this premium tax credit assistance means that you can get some amount that's scaled depending on where you are on that chart.

And this amount can be relatively substantial. So if your household income falls into one of those areas, then yes, you may qualify for the premium tax credit. Now here's the next question on the flow chart. Can you be claimed as a dependent on someone else's tax return? If yes, you're not eligible for the premium tax credit.

If no, you are not claimed as a dependent on someone else's tax return, then you might be eligible. Next would be is your filing status married filing separately? If you file as married filing separately, unless – there's one exception, two exceptions. Unless a tiny exception for spouses who are not – no, I was going to say for spouses who are married persons living apart but they would file as unmarried.

The only exception is if you are the victim of domestic abuse or a spousal abandonment. Then you can file a return as married filing separately and you will be eligible for the premium tax credit. But beyond that, unless you meet that definition of a victim of domestic abuse or spousal abandonment, you will not be able to file and receive this tax credit if you are married filing separately.

All else single, married filing jointly, et cetera, everything else is covered. Next were all the premiums paid is the next question. If no, not all the premiums were paid, then you're not eligible for the tax credit. If yes, then you may be allowed a premium tax credit. So those are the basic things that you need to be aware of for eligibility for this.

If you – and I'll run through them again very quickly. If you don't qualify, this will be largely intellectual for you, academic, or you may just want to skip from here. If you do qualify, then pay attention to the information in today's show. So again, did you enroll through the marketplace?

You must have enrolled through the marketplace. The answer is yes. Are you and any of your family members eligible for coverage through an employer or government fund? You have to not be eligible for coverage elsewhere. Is your household income at least 100% but no more than 400% of the federal poverty line?

If your household income is higher than that number, you will not be eligible for the premium tax credit. You can't be claimed as dependent on someone else's tax return. You can't file as married filing separately and you have to pay all the premiums for your insurance. If those things are covered, then your premium tax credit may be available to you.

Let's talk about those income bands because with regard to eligibility, that will make the biggest difference for many of you, saying, "How do I fit into that 100% to 400% of the federal poverty level if I want to take advantage of this tax credit?" Those income bands are measured based upon modified adjusted gross income.

Now anytime you see this word modified adjusted gross income, there's no formal definition of modified adjusted gross income that's universally applicable. The adjusted gross income will come directly from your tax return. It will be line 37, which is the front page of your 1040 bottom line. That is your adjusted gross income.

But then it's going to be modified in some way and the way that it's modified will depend on what tax credit we're talking about or what particular rule that we're discussing. In this case, for the premium tax credit, the modified adjusted gross income is your adjusted gross income plus any income that wasn't reported due to the foreign earned income or housing cost assistance exclusions plus any tax exempt interest, for example, muni bond income, and any social security benefits that were excluded from the income for other reasons.

Those numbers need to be added back to calculate your modified adjusted gross income. So we'll pause right here for a moment. If you look at your adjusted gross income number and if that number is within the range, then you're going to be good to go. Of course, the lower the better because you'll be able to get a higher tax credit.

But recognize that there are a number of things that come into play with your adjusted gross income. So first of all, remember that all of the forms of income have been listed here, but that some of the forms of income that are listed at the top of your 1040 will be flowing onto this form after a business return.

So that's an important reason why I recommend to you that you make sure that you be better off when it comes to tax planning by owning and operating a business. Because if you can entitle yourself to some number of business deductions, that will have an impact up front on offsetting some of your business income.

Also recognize that there are other aspects of your investments and other aspects of your business and investment activities that are already calculated. So for example, your real estate income might flow flows in as income, but it flows in as income after you've taken your depreciation expenses. Those are all helpful for getting your income down.

Secondly, you should notice that your adjusted gross income is arrived at by taking your total gross income and adjusting it for certain deductions. Again, just reading from the front of the 1040, those deductions, those adjustments will be educator expenses, some business expenses of reservists, performing artists, and fee basis government officials, health savings account deductions, moving expenses, deductible part of self-employment tax, self-employed SEP simple and qualified plans, self-employed health insurance deduction, penalty on early withdrawal of savings, alimony paid, IRA deductions, student loan interest deductions, tuition and fees, domestic production activities deduction, and that's the extent of the lines.

Those are all deducted before you arrive at your adjusted gross income. Why is this important? Well, the people who've got the sweet spot with regard to tax planning are those who can live on a relatively low amount of money, but who can earn a much higher amount of money.

When you come to something like the premium tax credit, if you can figure out a way to earn a higher amount of money, have some amount of that income sheltered by depreciation expenses, business expenses, capital improvement expenses, and set up by having low expenses, you can save a significant amount of your income, set up aggressive savings plans through tax-deferred and tax-deductible savings plans such as IRAs, SEP simples, 401(k)s, etc.

If you have options of those things, you can get your income relatively low. And this tax credit is one where if you're buying your health insurance through the federal health insurance exchange, this tax credit is one that can add up significantly in terms of actual benefits received. You'll have to run the math for yourself and on your own situation.

But if you have, like I do, a family of four and you're saying, "Okay, how much would it cost for me to get the insurance coverage?" Find out what the cost is without the premium tax credit, then find out what your cost would be with your premium tax credit, and see if there's a way where you can maximize the premium tax credit.

And by maximizing it and getting your income to the point where it can be maximized, you may find a substantial savings there. And what also you should pay attention to is that the premium tax credit is actually a refundable tax credit. So if you're good with other aspects of your health, excuse me, your tax planning, it's my understanding that this credit is a refundable credit, which you may be able to use to get more out than you put in.

So not all the tax credits are refundable, but this one is. And so you should calculate it carefully and look at your situation carefully. So how does the credit actually work? Well, the basic goal of the credit is to limit the premiums that you pay to the health insurance marketplace, to your health insurer that you purchase through a marketplace, to a certain percentage of your income.

So there are two aspects of it. Most uniquely, this is a credit that can actually be paid to the insurance company. When it's done in the language of the IRS, this is what's called the advanced premium tax credit. That's where they advance it to the health insurance company so that your out-of-pocket payment is very low.

And then everything has to be settled and reconciled at the end of the year when you file your tax return, but the credit was advanced to the insurance company. So if you were to go to the markethealthcare.gov right now during open enrollment and you sign up for a plan, normally your plan is going to cost you $600 a month.

But because of your eligibility for the premium tax credit, the marketplace system calculates that based upon the data that you enter, you will be eligible for a $300 a month tax credit, a total of a $3,600 tax credit. You will not have to pay the insurance company $600 and collect your $3,600 at the end of the year.

You wouldn't have to pay them $600 a month and then collect your one-time credit of $3,600 at the end of the year. Rather, you'll just simply pay the insurance company $300 per month ongoing. And then when you file your taxes next year, that number will be reconciled. And if your income increased dramatically, then you'll owe the government more money because your credit went down.

Or if your income decreased or some other family situation changed, then you'll get a larger refund from them because you were eligible for more of a credit. That's how functionally it works with the system of the advanced premium tax credit. I'm not aware of any other tax credit that works like this in the sense of it being on an advanced basis.

All of the other tax credits that I'm aware of presently, all of these function on the basis of when you actually file your return. That's when the credits are calculated and that's when you receive the benefit for them. The functional goal of the credit, the way that they calculate the premiums, is to keep the premium level at a certain target of your income.

So starting off at 100% of the federal poverty level, that number, so again, where's my chart? Family of four, that would be if you have a household income of about $25,000 per year, then the goal of the premium tax credit is to limit your health insurance premiums to about 2% of your income.

And this would increase. Let's say you're at 200% of the federal poverty level, well, 200% of the federal poverty level for that family of four, then at this, which would put you at $48,500 of annual income, then they're trying to limit your premiums to about 5% of your income.

Or if you're at the higher amounts, where let's say you're up at three or three to 400% of the federal poverty level income, again, family of four, that's going to put you between $73,000 and $97,000. Then they're trying to limit your premiums that you're paying for health insurance to about 9.5% of your income.

That means that this credit is one that is much, much, much more valuable for those with a low income than for those with a high income. And it's substantially weighted towards being much more valuable for the low income, the person who reports a low income. The reason for this is the underlying benchmark is not something that's based upon income, but rather something that's based upon a flat expense.

The credit is calculated as the excess of the premium cost for what they call a benchmark plan over the threshold amounts that I just read to you, those ranges. I'm trying to use fewer numbers on an audio show. It's relatively simple when you fill out the forms. Just grasp the concept.

So they calculate the excess of the premium cost as much as it costs over that percentage amount. And the higher the percentage amount, the more the credit is. Now the benchmark plan cost is not going to change. That's going to be the second lowest cost silver plan that's available on the exchange to cover your entire household based upon the age and where you live and the number of people in the family.

So that will change significantly depending on where you live and what type of market you're in locally. Incidentally, they don't change it based upon smokers. So if you're a smoker, you're going to pay a higher amount than those who are non-smokers is based upon non-tobacco use. That's what the benchmark plan is.

So they'll calculate that as the second lowest cost silver plan in your marketplace and then they'll take everything from the cost that goes above that target percentage. Again, that target percentage ranged from 2% to 9.5% of your income depending on which of those tiers you ranged into. And the credit will be as much as everything above that.

Because of this reality, it's led to a very interesting scenario in our current day and with all the arguments over the Affordable Care Act. As premium costs have increased for the actual policies, thus because the cost of insurance have gone up, the actual amount of money out of pocket for the majority of people who are receiving subsidies, which is the majority of people on the Affordable Care Act exchange, those out-of-pocket rates are not increasing as much as the underlying premiums are increasing.

It's because the credit amounts are not tied to the actual expenses of the insurance. They're tied to the federal poverty level with the goal of keeping them down. So in essence, the taxpayers who are subsidizing the premium tax credit here are the ones who are picking up the bill for the increasing premiums.

That's why there's such a disconnect often, depending on what articles you're reading about the changes in the premiums for Affordable Care Act policies. A couple of things also to point out about these brackets. First, this bracket, if you are near the top end of a range and if you're eligible for the premium tax credit assistance, for the premium tax credit, if you're near that 400% number, you should be aware that there is a massive cliff and it is probably within your best interest not to go over that cliff in terms of the actual amount of money that you are earning.

Let's say as an example here that you are a family of four and for a family of four, 400% of the poverty level would be $97,000 per year. Well, if you come in with a modified adjusted gross income of $96,999, your premiums will be limited to 9.5% of your income.

If we run the math for $96,999, 9.5%, that means that any costs over $9,214.91 out of your pocket, any costs out of that will be picked up by this tax credit. You'll be paying a total of $9,200 per year or $767 per month, but anything over that is going to be picked up by this premium tax credit.

But if you earn $97,001 as your modified adjusted gross income, that means the total cost of the policy will be borne by you and you'll lose all of it. So that could be a difference of say something like a $3,000 or $4,000 tax bill. If the cost was $99,000 with the tax credit but the actual cost of the policy is $12,000, then if you go a dollar over a $97,000 income, you'll wind up with an extra $3,000 expense out of your pocket.

So be very careful of that if you're near that 400% number. And if, again, all those caveats apply, if you're receiving your insurance through the exchange, etc., don't go over that 400% number. Take a month off and work less and you'll come out ahead just by being under that number.

There is a cliff there. I think that tip can actually apply to a number of you in the audience that I know are fine income earners. Due to your family size, you can live on a lower amount, but yet the cost of health insurance is significant. So pay attention to that and see if there's a way to use that.

The other thing you need to pay attention to, of course, is that all of these things are based upon income. All of these calculations are based upon income, not on assets. And there is no asset test for this tax credit just like anything else. You may have millions of dollars under your control, but as long as you're not recognizing income from that, you will be qualified for this potential tax credit.

So for many of you who are very good at keeping expenses down and who are very good at controlling the income that your portfolio is throwing off of, this should make a big difference for you. So as a matter of planning, basically you got three groups of people. If you're making more than 400% of the federal poverty level of income for your household size, you're going to pay for the full cost of the insurance with no tax credit.

If you're between 133% and 400%, then there's going to be a sliding credit available to you. And if you're below 133% of that federal poverty level, that's where you are basically not going to pay any premiums and you're going to be covered by Medicaid. So that's where you want to pay attention to what bracket you're in and what bracket you're considering.

I think I've covered enough here for today. If you're interested more on the premium tax credit, publication 974 is the document that you want from the IRS, publication 974. I will link it in the show notes for today's show directly over to the IRS. I've read it through. There are other details that I could go into, but there are just really not – there are no other major planning benefits that I've found, no other major ways to exploit this credit for your benefit.

I've shared with you the best I know. So feel free to go and read it, but I think all the other details that are there are just not relevant enough to the audience as a whole to be worth it. But definitely, this is something that you should pay attention to and this is one of those – the benefit can be substantial.

So pay careful attention to this premium tax credit. We'll be continuing the health insurance series. The next one that I am planning is to talk about the penalty. If you don't have health insurance, who is eligible for an exemption from the penalty, how to get out of it, what happens if you don't pay the penalty, talk about some of the strategies.

I plan at some point here to talk about health savings accounts. I'll also talk about healthcare sharing ministries, a number of other episodes in this series as well. So thank you for listening for today's show. I hope it's been useful. I would be thrilled if you have gained value from this show.

I'd be thrilled if you supported the show on Patreon. That's the primary way that I earn income from the show. You can find out all those details at RadicalPersonalFinance.com/patron. Thank you to the several hundred of you who support me there. I deeply appreciate you and all of the help that you are to me in my work.

Secondly, I offer phone consulting. So if you'd like to speak with me personally, it can be about a tax issue, it can be about anything else, feel free to connect with me. You can book a phone call with me, a consulting phone call at RadicalPersonalFinance.com/phone call. Again, RadicalPersonalFinance.com/phone call to be able to book that appointment with me.

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