Since 2000, federal employees have participated in “premium conversion”. They do so when they pay their portion of the Federal Employees Health Benefits (FEHB) program health insurance premiums. During the upcoming federal employee benefits open season that runs between Nov. 12, 2018 and Dec. 10, 2018, employees can decide whether they want to continue to participate in “premium conversion” during the 2019 plan year.
This column explains what premium conversion is, how employees save and benefit from it, and why, under a portion of the new tax law due to take effect Jan. 1, 2019, most employees will benefit more through participation in premium conversion.
What is premium conversion and how does it work?
Under a health insurance premium conversion arrangement, an employee’s FEHB health insurance premium is deducted from the employee’s gross salary. The amount of the employee’s taxable salary is therefore reduced. In particular, for Federal employees, the FEHB premiums are first deducted and the appropriate taxes are then applied as follows:
Federal income taxes
Like employee contributions to the traditional Thrift Savings Plan (TSP), FEHB premiums are deducted from the employee’s gross salary before federal income taxes are applied.
State and local taxes
Like employee contributions to the traditional TSP for employees living in most states that have state and local income taxes, FEHB premiums are deducted from the employee’s gross salary before state and local income taxes are applied. Each state and local government make an individual determination as to whether to allow the pre-tax treatment for health insurance premium deductions under premium conversion plans.
Social Security (FICA) and Medicare Part A (hospital insurance) payroll taxes
Unlike employee contributions to the TSP, FEHB premiums deducted from the gross salary of those employees participating in premium conversion will be excluded from the employee’s gross salary before OADSI (Social Security and Medicare hospital insurance) payroll taxes are applied. Employer OADSI contributions will also be reduced in conjunction with the decrease in the employee’s gross salary.
The following example illustrates:
Ken, age 45, each pay date has a gross salary of $2,000. He contributes $100 to the traditional TSP each pay date. His FEHB health insurance plan premium each pay date is $150. Ken is in a 22 percent Federal income tax bracket and in an eight percent state tax bracket. Ken’s take-home each pay date with and without premium conversion is presented in the chart below.
As can be seen from this example, there is an increase in net take-home pay as a result of premium conversion participation. In Ken’s case, he has $56.47 in net additional take-home pay as a result of premium conversion.
Note that participation in premium conversion will have no effect on other federal employee benefits. For example, deductions from CSRS and FERS employee contributions to the Retirement and Disability Funds, and percentages of pay contributed to either or both the traditional or Roth TSP are based on an employee’s current SF-50 gross salary with no offset for premium conversion. The amount of an employee’s FEGLI Basic Insurance Amount (BIA) is not affected by premium conversion participation. The BIA is an employee’s SF-50 salary rounded up to the next $1,000, plus $2,000.
But participation in premium conversion means that an employee cannot include the FEHB premiums deducted as before-taxed dollars as qualifying expenses deductible medical expenses on his or her federal income tax return on Schedule A (itemized deductions). It should be noted that for tax year 2018, in order for an individual to deduct qualifying medical and dental expenses as itemized deductions on Schedule A, the total amount of qualifying expenses would have to exceed 7.5 percent of the individual’s adjusted gross income (AGI). But under the new tax law (the Tax Cuts and Jobs Acts of 2017 or TCJA), effective January 1, 2019 the 7.5 percent of AGI “floor” increases to 10 percent of AGI “floor”. This means fewer employees will be able to deduct qualifying medical and dental expenses, and premium conversion participation will therefore benefit more employees in the form of lower federal and state tax liabilities.
Federal annuitants who are enrolled in the FEHB program cannot participate in premium conversion. They must have their FEHB premiums deducted from their CSRS or FERS annuities with after-taxed dollars. But an annuitant who is re-employed in a federal job that conveys FEHB eligibility is automatically covered by premium conversion, unless the re-employed annuitant waives participation.
Are there any disadvantages associated with premium conversion?
A non-financial disadvantage associated with premium conversion involves changes to FEHB enrollment. Employees who do not participate in premium conversion are able to cancel their FEHB enrollment or change from self and family or self plus one enrollment to self only enrollment at any time during the year. Employees who participate in premium conversion will be able to make these changes in their FEHB enrollment only during the FEHB open season, held each year from the second Monday of November to the second Monday of December, or after a qualifying life event. Some examples of qualifying life events include:
- birth or adoption of a child;
- death of a spouse or a dependent;
- divorce or annulment;
- commencement or return from an unpaid leave of absence; or
- significant changes in the health coverage of the employee or the employee’s spouse, related to the spouse’s employment.
As discussed above, those employees who participate in premium conversion have their FEHB premiums deducted from their gross salaries before all taxes. These taxes include federal and state income taxes, Social Security (FICA) and Medicare Part A (hospital insurance) payroll taxes. A participating employee’s taxable Social Security and Medicare wages are therefore reduced each year, as shown on the employee’s W-2 statement that the employee receives in January following the year of earned income.
Since the Social Security Administration (SSA) calculates an individual’s future retirement benefits based on the individual’s 35 highest Social Security wages during the employee’s working years, the reduction in Social Security wages resulting from “premium conversion” will affect the individual’s future Social Security retirement benefits. However, as illustrated below, the relatively small reduction in future Social Security retirement benefits is greatly outweighed by the current annual larger tax savings. The following formula procedure can be performed to estimate the difference in an individual’s Social Security benefit as a result of participation in premium conversion:
- Take the number of years an employee will participate in premium conversion (until retirement) and divide by 35.
- Multiply the amount in #1 by the amount of the employee’s current annual FEHB premium.
- Multiply the result in #2 by the marginal SSA rate (15 percent for most federal employees).
The result is the annual loss of Social Security benefits: (number of years of premium conversion/35) x the annual FEHB premium x the marginal SSA rate) = the annual loss in Social Security retirement benefits
The following example illustrates:
Kathy began her federal service at age 40 and will retire from Federal service at age 60 with 20 years of premium conversion participation. She has had a full career of FICA tax contributions, with an ending salary of $100,000 and a projected Social Security retirement benefit at age 66 of $2,200 per month. Kathy’s annual FEHB premiums are $2,000 per year.
As a result of premium conversion participation, this reduces her Social Security wages by $2,000. Kathy is in a 22 percent Federal tax bracket and in an eight percent state tax bracket. Each year Kathy is saving in total taxes:
.22 + .08 + .062 + .0145 = .3765 x $2,000, or $753.
The reduction in Kathy’s future Social Security retirement benefits is calculated as:
20/35 x $2,000 x 0.15 = $171.
The $171 annual loss in Kathy’s future annual Social Security retirement benefit is compared to the annual $753 increase in Kathy’s net take-home pay resulting from the total tax savings.
Those employees who choose not to participate in premium conversion need to do so during the open season. They need to contact their Human Resources or Personnel Office to request the form waiving premium conversion during 2019. If in the future they want to re-participate in premium conversion, they will have to complete the proper form during a future open season.
Finally, those employees who are enrolled in dental and/or vision insurance through the Federal Employees Dental and Vision Insurance Program (FEDVIP) also participate in premium conversion. Unlike the FEHB program, FEDVIP enrollees do not have the option to opt out of premium conversion.