Edward A. Zurndorfer –
Each year during the Office of Personnel Management (OPM)’s sponsored benefits “open season”, employees and annuitants make decisions regarding which health, dental and vision insurance plans they want to be covered by during the upcoming plan (calendar) year that starts in early January. Another decision with respect to their Federal Employee Health Benefits (FEHB) program insurance plans that employees have to make is whether or not they want to continue participation in “premium conversion”. This column is the second of eight FEDZONE columns discussing choices that employees and annuitants have to make during the annual benefits “open season” which this year runs from November 9, 2020 through December 14, 2020. “Premium conversion” is explained including some of its advantages and disadvantages.
What is “Premium Conversion”?
“Premium conversion”” is an arrangement in which employees (but not annuitants) pay their portion of their FEHB program health insurance premiums using “before-taxed” salary dollars. “Before taxed” salary means before all taxes – this includes Federal and state income taxes (most states), Social Security (FICA) and Medicare Part A (hospital insurance) payroll taxes – are deducted from an employee’s gross salary to pay the health insurance premiums due each pay date. The following example illustrates:
Paula is enrolled in the FEHB program (self and family coverage) and pays $500 in FEHB health insurance premiums each pay date for her FEHB program health insurance plan. The $500 is deducted from Paula’s gross salary to pay the premium due. Assuming Paula is in a 24 percent federal marginal tax bracket and in an 8 percent state marginal tax bracket, Paula saves the following amount in total taxes by having the full $500 deducted from her gross salary to pay the FEHB program premium due:
24 percent (federal tax bracket) plus 8 percent (state tax bracket) plus 6.2 percent (FICA payroll tax)
plus 1.45 percent (Medicare Part A payroll tax)
equals 39.65 percent
39.65 percent of $500 equals $198.25
Over 26 pay dates (one year) Caroline is saving 26 times $198.25, or $5,154, in total taxes through participation in “premium conversion”.
Note that the FEHB Insurance premiums deducted under “premium conversion” are not subject to either income (federal and state) or payroll (Social Security – FICA and Medicare Part A – hospital insurance) taxes. This is somewhat different than traditional Thrift Savings Plan (TSP) contributions in which the employee’s contributions are deducted from the employee’s gross salary – before federal and state income taxes – but after Social Security and Medicare Part A payroll taxes are withheld, and the employee pays Federal and state income taxes upon withdrawing the traditional TSP account.
Employees who enroll in the FEHB program and in the dental and/or vision insurance offered through the Federal Employees Dental and Vision Insurance Program (FEDVIP) are automatically enrolled in “premium conversion” and cannot waive “premium conversion”. Under IRS rules, annuitants are not allowed to participate in “premium conversion”. Annuitants who are enrolled in the FEHB program and the FEDVIP by law must have their premiums deducted from their after-taxed annuities. Their CSRS and FERS annuities are not subject to FICA and Medicare Part A payroll taxes and, in several states, are not subject to state and local income taxes.
Employees have the option of waiving “premium conversion” with respect to their FEHB program premiums. They do not have the option of waiving “premium conversion” with respect to their dental and vision insurance premiums under the FEDVIP. The question then becomes: Why would an employee want to waive “premium conversion” for their FEHB program premiums and therefore forgo the associated tax savings? Possible reasons include: (1) Flexibility; (2) include the FEHB program premiums as a medical expense itemized deduction; and (3) the effect on future Social Security retirement benefits. These reasons are now discussed.
- Flexibility. An employee participating in “premium conversion” generally has the same flexibility with respect to making changes to their FEHB program benefit as an employee who chooses not to participate. But tax law gives two exceptions. If an employee waives “premium conversion”, then the employee will have the flexibility to either drop his or her FEHB insurance altogether or to change from “self and family” or “self plus one” enrollment to “self only” enrollment at any time of the year without giving any reason. An employee who participates in “premium conversion” will be allowed to drop FEHB coverage, or to change to “self only”, enrollment only during an “open season” or if the employee experiences a “qualifying life event” such as marriage or the employee’s spouse has a job in which the spouse enrolls in the job’s group health insurance plan. But this flexibility to change for any reason is generally of little or no value compared to the tax savings associated with “premium conversion”.
- Including FEHB health insurance premiums as itemized medical expenses on Schedule A. By being enrolled in “premium conversion”, an employee is not permitted to include the employee paid portion of the FEHB program premiums deducted from gross salaries as medical expenses on Schedule A of their federal income tax returns, assuming the employee itemizes on his or her federal income tax return. In order for an individual to deduct their out-of-pocket medical, dental and vision expenses, the total expenses would have to exceed 7.5 percent of the individual’s adjusted gross income (AGI). Most employees will not have enough in out-of-pocket medical-oriented expenses in order to deduct these expenses. By including the FEHB premiums as part of their out-of-pocket medical expenses, an employee’s out-of-pocket medical, dental and vision expenses could exceed the 7.5 percent of the AGI threshold. But for employees who do not itemize on their federal income tax returns and instead take the standard deduction, “premium conversion” makes complete sense.
- Effect on future Social Security benefits. As previously mentioned, “premium conversion” means paying one’s FEHB health insurance and FEDVIP dental and vision premiums with “before-taxed” dollars, including FICA (Social Security). Each year, an employer reports employee Social Security wages (shown in Box 3 – “Social Security Wages” – of the employee’s W2) to the Social Security Administration. Participation in “premium conversion” therefore results in lower Social Security wages for a participating employee. Since the Social Security Administration determines an individual’s future Social Security retirement benefits based on the individual’s 35 highest years of Social Security earnings, participating in “premium conversion” could result in a slightly lower Social Security retirement benefit when the individual files for that benefit. The extent of benefit reduction will depend on: (1) The employee’s retirement system. CSRS employees (who are not covered by Social Security) need not be concerned while CSRS Offset and FERS employees who do pay into Social Security are affected; (2) the employee’s salary compared with the Social Security maximum wage base ($137,700 during 2020); and (3) the number of years the employee has until retirement.
How “Premium Conversion” is Waived?
During the benefits “open season”, employees have the opportunity to elect or to waive their participation in “premium conversion”. An “open season” election to participate or to waive participation in “premium conversion” must be received by an employee’s employing agency no later than the last day of the “open season”. The effective date of the “premium conversion” waiver election is the same as the effective date of a FEHB election which is the first day of the first payroll period of the new leave year.
This year’s “open season” dates are Nov. 9, 2020 through Dec. 14, 2020. The start of the first payroll bi-weekly pay period of the 2021 leave year at most agencies will be Jan. 3, 2021. This means that employees who wish to enroll or to waive participation in premium conversion must do so no later than the close of business on Dec. 14, 2020, with an effective date of Jan. 3, 2021.
Employees should contact someone in their Personnel Office or Human Resources Office for the necessary paperwork and forms required to elect or to waive “premium conversion”.
A table of permissible changes in FEHB enrollment and “premium conversion” election may be downloaded here.
Edward A. Zurndorfer is a Certified Financial Planner, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street – Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While the employees of Serving Those Who Serve are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.