American College - Center for Special Needs

Tax Leveraged Financing Options for Medical Expenses Incurred by Families Caring for Those with Special Needs

Are Home Equity Loans and Retirement Plan Distributions Still Viable under Recent Legislation? As the number of children diagnosed with autism, Asperger’s syndrome, and other intellectual disorders continues to skyrocket, the lives of all of those concerned are dramatically impacted. Recent statistics indicate that as many as 1 in 54 children born today have an autism spectrum disorder (Centers for Disease Control, March 27, 2020… citing an increase from 1 in 59 according to the CDC on April 26, 2018 and 1 in 68, according to the CDC on both March 28, 2014 and March 31, 2016 with boys 4 times more likely to be identified with an ASD than girls). 

BY Thomas M. Brinker Jr., LL.M., CPA | November 2021 | Category: Financial Planning

Tax Leveraged Financing Options for Medical Expenses Incurred by Families Caring  for Those with Special Needs

In addition, the CDC cites in this same 2020 report that about 1 in 6 (17%) of all children aged 3 to 17 have been diagnosed with a developmental disability (such as autism, ADHD, blindness, and cerebral palsy among others) with almost 1 in 4 American adults nationwide having a disability. Parents caring for those with special needs are often unaware that substantial tax benefits may be available to them and often forego hundreds, if not thousands, of potential tax deductions and reductions in their tax liability. Although we have previously focused on the expanded definition of medical care as an income tax deduction and other tax benefits for our families, another reality inevitably surfaces… finding the wherewithal to finance these expenditures. Parents of children with special needs quickly discover that medical care expenditures for their child can prove astronomical. As a result, parents and their advisors need to become familiar with some unusual Internal Revenue Code provisions that may assist in and/or hinder this process. This article focuses on two common resources often utilized in financing medical care: home equity loans and distributions from retirement plans and individual retirement accounts (IRA). 

Overview of the Medical Expense Deduction

Only individuals itemizing deductions on their federal individual income tax returns can claim a medical expense deduction. Unreimbursed medical expenses are currently deductible only to the extent they exceed 7.5% of a taxpayer’s adjusted gross income or AGI as of 2017 (Sec. 213(a)). The 7.5% AGI threshold represents a permanent reduction in the AGI threshold as of 2021 under December of 2020’s Taxpayer Certainty and Disaster Tax Relief Act of 2020 (The Tax Cuts and Jobs Act “TCJA” had reduced the threshold for deducting medical expenses from 10% of AGI to 7.5%, but only for 2017 and 2018 originally with extensions of the 7.5% threshold occurring thru 2020.) Alternatively, parents who are eligible to participate in tax-advantaged plans through their employers for funding medical expenses, such as flexible spending accounts or health savings accounts, can set aside limited amounts of money to finance medical care expenses on a pre-tax basis while bypassing the AGI limitation. Unfortunately, pre-tax contributions are currently limited to $2,750 as of 2020, receiving annual indexed adjustments for inflation (Patient Protection Act, as amended by the Health Care and Education Reconciliation Act of 2010). 

Financing Options for the Medical Expense Deduction

Treasury Regulation 1.213-1(e)(1)(v) permits the unreimbursed cost of attending a special school for an individual having an intellectual or physical disability as a medical expense deduction if the principal reason for the individual's attendance is to alleviate the disability through the resources of the school or institution. This deduction may also include amounts paid for lodging, meals, transportation, and the cost of ordinary education incidental to the special services provided by the school. Also, any costs incurred for the supervision, care, treatment and training of an individual with a physical and/or intellectual disability are deductible if provided by the institution. Unfortunately, it is not uncommon for this expenditure alone to exceed tens of thousands of dollars.

Furthermore, qualifying capital expenditures, medical conferences and seminars, prescribed vitamin therapy, therapeutic assistance, various therapies, and special diets can add thousands of dollars to the medical expense deduction annually.

Barring savings, investments, and extended family assistance, many parents caring for children with special needs are often left with few choices for financing their child’s medical expenses and resort to home equity loans and retirement plan distributions. These rules also apply to any taxpayer with significant unreimbursed medical expenses. 

Are Home Equity Loans Still a Viable Solution?

Families commonly borrow against their homes in financing their medical expenses. Although interest expense incurred on a home equity loan is no longer deductible as an itemized deduction, there are exceptions as discussed below.

In general, home equity loans represent borrowings other than the indebtedness incurred in acquiring a principal residence and/or a second home. Under prior law, in order to qualify the interest expense for an itemized deduction, the tax law limited home equity indebtedness to the lesser of:

  • The excess of the fair market value of the qualified residence (principal and/or second home) over the balance of the original/acquisition indebtedness incurred with respect to the residence(s), or
  • $100,000 with a $50,000 limit for married couples filing separately (Sec. 163(h)(3)(C)).

The $100,000 limit, as well as the $1,000,000 limit on acquisition indebtedness, was applied on a per-taxpayer basis, and not as a per-residence limitation. These are separate limitations. The maximum amount of indebtedness qualifying for a mortgage interest expense deduction was therefore $1,100,000 ($550,000 for married couples filing separately) under prior law (Sec. 163(h)(3)).

Under the TCJA, the rules have changed (See Sec. 163(h)(3)(F): “Special Rules for taxable years 2018 through 2025”). As of 2018, the home mortgage interest deduction is limited to acquisition indebtedness of $750,000 (from prior law’s $1,000,000) for homes acquired after 2017. Further, the home equity loan interest deduction is being suspended through 2025. As of 2018, parents seeking an interest expense deduction for home equity indebtedness will only be permitted a deduction if the loan is to purchase, construct, or substantially improve a residence. A home equity loan interest deduction will be permitted if the parents secure the loan for medical capital expenditures (i.e., substantially improving the home) made to the home in accommodating the child with special needs (with total indebtedness limited to $750,000). However, utilizing a home equity loan to finance ongoing medical care will not result in an interest expense deduction. 

Example:

Michael Cynthia Plear made a $200,000 down payment and borrowed $550,000 to purchase a residence worth $750,000 in 2015. Their home is currently valued at $925,000 with an acquisition debt remaining of $500,000. In 2020, they borrow $200,000 to provide for the ongoing medical care of their 16-year-old daughter with special needs, and use their residence to secure this note.

They may deduct interest on the $500,000 of remaining acquisition debt only unless the $200,000 home equity loan was utilized to improve the home, such as a medical capital expenditure (e.g., installing an elevator or therapeutic swimming pool, constructing entrance ramps, widening doorways and halls, lowering kitchen cabinets, and adding railings.) 

Are Retirement Plan and IRA Distributions the Answer?

In addition to obtaining home equity loans, families caring for children with special needs often take early distributions from their retirement plans, IRAs, and annuities to finance their medical expenses. Although a 10% penalty exists as a disincentive for early retirement and pre-retirement withdrawals (i.e., prior to age 59 ½), there are exceptions to the penalty for distributions not in excess of the medical expense deduction.

The 10% penalty does not apply to distribution amounts that are less than or equal to an individual’s allowable medical expense deduction in excess of 7.5% of AGI (regardless of whether the individual actually itemizes deductions) if the distributions are used to pay for the medical care during the year (Sec. 72(t)(2)(B)). The penalty waiver only applies to that component of the distribution which is included in gross income. The income tax still applies to the taxable component of the distribution. The law does not require that individuals first deplete the 10% penalty exception for medical care by using the non-taxable component of a distribution, such as a non-taxable return of investment (Argyle v. Commissioner, T.C. Memo, 2009-218). A Form 5329 with an accompanying medical expense worksheet (or Schedule A for itemizers) must be attached to Form 1040, indicating Exception 5 on Line 2 of the Form. 

Examples:

1. Without Itemizing Deductions and Claiming the Standard Deduction: Mr. and Dr. Nolan, both age 50, have an AGI of $40,000 for the year 2020, which includes an early retirement plan distribution. The Nolan family incurs and actually pays $9,500 in qualifying medical expenses during the year. The allowable medical deduction will be the amount of medical expenses that exceeds 7.5% of $40,000 or $3,000. Although the Nolans claim the standard deduction of $24,800 for 2020, their allowable medical expense deduction for 2020 would have been $6,500 ($9,500 in medical expenses less $3,000) had they itemized deductions on their Schedule A. In this example, a $5,000 taxable distribution from an IRA or retirement plan would not be subject to penalty. However, if the taxable distribution was $8,000, only $6,500 would escape the 10% penalty. The balance of the distribution, $1,500 will be subject to a 10% penalty of $150.

2. When Itemizing Deductions: Dr. and Mrs. Kim, both age 40, have an AGI of $150,000 for the year 2020, which includes an early retirement plan distribution. The Smiths incur (and actually pay) $27,500 in qualifying medical expenses during the year. The allowable medical deduction will be the amount of medical expenses that exceeds 7.5% of $150,000 or $11,250. Their allowable deduction for 2020 is $16,250 ($27,500 in medical expenses less $11,250). In this example, a $15,000 taxable distribution from an IRA or retirement plan would not be subject to penalty. However, if the taxable distribution was $21,000, only $16,250 would escape the 10% penalty. The balance of the distribution, $4,750 will be subject to a 10% penalty of $475. 

Note: The key to this penalty exception in both examples – The taxpayers must have actually paid the medical costs during the year. However, there is a caveat: to the extent the distribution is included in gross income, AGI increases, reducing the medical expense deduction and increasing the distribution’s exposure to the penalty!

It should also be noted that with regard to an IRA distribution, the law applies the medical expense exception before other exceptions; notably, the first-time homebuyer and education exceptions (Sec. 72(t)(2)(E) and (F)). As a result, families with significant unreimbursed medical expenses may wish to consider utilizing the medical expense exception first with regard to retirement plan distributions, availing themselves of the first-time homebuyer and educational exceptions under the IRA distribution rules (Blankenship, Vorris “Retirement Plans, IRAs, and Annuities: Avoiding the Early Distribution Penalty” The Tax Advisor, April 2011, p. 260).     

Conclusion:

This article provides a brief overview on the medical expense deduction and two common tax-savings opportunities in financing the medical expense deduction. As parents and advisers, it is important to understand that substantial tax benefits are available to those caring for children with special needs and the medical care financing options available that provide either a tax incentive or disincentive.

(Reprinted in part with permission from MassMutual’s SpecialCare Spring 2020 Newsletter)

ABOUT THE AUTHOR:

Thomas M. Brinker, Jr., CPA/PFS, ChFC®, CGMA, CFE, AEP is Professor of Accounting at Arcadia University in Glenside, Pennsylvania. He is currently Executive Director for their MBA program and serves as Chair for the MassMutual Center for Special Needs Planning at the American College of Financial Services in King of Prussia, Pennsylvania. He graduated cum laude from Saint Joseph’s University in Accountancy, and holds master’s degrees in Taxation and Accounting from Widener University. In addition to earning his J.D., Professor Brinker earned an LL.M. in International Taxation from Regent University School of Law, where he received the distinction of “Outstanding Graduate” in his class. Mr. Brinker is also a member of the American and Pennsylvania Institutes of Certified Public Accountants, the International Bar Association, and the Caribbean Bar Association. In addition to presenting nationally and internationally on various tax topics, he has published dozens of articles in numerous journals, including The Journal of Accountancy, The Journal of International Taxation, The Tax Adviser, The CPA Journal, The Journal of Practical Estate Planning, and The Journal of Financial Services Professionals. 

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