The number of children diagnosed with autism and other intellectual disorders continues to skyrocket, affecting the lives of all those concerned. Recent statistics indicate that as many as 1 in 59 children born today has an autism spectrum disorder (The Centers for Disease Control on April 26, 2018, cited the increase from 1 in 68 in March 2016 representing another significant increase from the reported 1 in 88 children in 2012 and 1 in 110 in April 2010). As discussed in the June 2013 Journal of Accountancy article, "Potential Income Tax Benefits for Families with Special Needs Children," parents caring for children with special needs are often unaware of the substantial tax benefits available to them and often forgo hundreds, if not thousands, of dollars in potential tax deductions and reductions in their tax liability.
Although the focus in the 2013 article was on the expanded definition of medical care and other tax benefits for those 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 children can prove astronomical. As a result, parents and their advisers need to become familiar with some little-known Code provisions that may assist in and/or hinder this process. This article focuses on two common resources often used in financing medical care: home equity loans and distributions from retirement plans and individual retirement accounts (IRAs).
Overview of the medical expense deduction
As discussed in the 2013 JofA article, only individuals itemizing their deductions on their federal individual income tax returns can claim a medical expense deduction. Unreimbursed medical expenses are deductible only to the extent they exceed 10% of a taxpayer's adjusted gross income (AGI) as of 2019 (Sec. 213(a)). Although the threshold increased to 10% of AGI as of 2013, it had remained at 7.5% of AGI for individuals age 65 and older for tax years through 2016 (both of those provisions were enacted by the Patient Protection and Affordable Care Act (PPACA), as amended by the Health Care and Education Reconciliation Act of 2010, P. L.111-148, Section 9013. The law known as the Tax Cuts and Jobs Act of 2017 (TCJA), P.L. 115-97, retroactively extended the 7.5% AGI threshold to all taxpayers, regardless of age, for 2017 and 2018.
Taxpayers who are eligible to participate in tax-advantaged plans through their employers for funding medical expenses, such as flexible spending accounts (FSAs) or health savings accounts (HSAs), can set aside limited amounts of money to finance medical care expenses on a pretax basis while bypassing the AGI limitation. The amounts that can be contributed pretax to an FSA or HSA are subject to inflation-adjusted limits.
Pretax contributions to flexible spending accounts are limited in 2019 to $2,700. The contribution limit to an HSA for 2019 for individuals with self-only coverage under a high-deductible health plan is $3,500 ($7,000 for individuals with family coverage).
For 2019, a high deductible health plan for HSA purposes is defined as a health plan with an annual deductible that is not less than $1,350 for self-only coverage or $2,700 for family coverage, and annual out-of-pocket expenses (deductibles, co-payments, and other amounts, but not premiums) of not more than $6,750 for self-only coverage or $13,500 for family coverage. These amounts are also indexed annually for inflation.
Financing options for the medical expense deduction
Regs Sec. 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 the school provides. 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 taxpayers' medical expenses annually.
Barring savings, investments, and extended family assistance, many parents of 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 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, for purposes of the deduction for qualified residence interest, home equity loans are indebtedness secured by a qualified residence (a principal residence and/or a second home) other than acquisition indebtedness (debt incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer secured by that residence). Under the law prior to 2018, to a deduction was only allowed for interest expense on home equity indebtedness equal to the lesser of:
- The excess of the fair market value of the qualified residence over the balance of the 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 million 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 new 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 (down from prior law's $1,000,000) for homes acquired after 2017. Further, the home equity loan interest deduction is 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. Thus, a deduction for home equity loan interest will be permitted if the parents obtain a home equity loan to make medical capital expenditures (i.e., substantially improving the home) to the home in accommodating the child with special needs (with total indebtedness limited to $750,000). Using a home equity loan to finance ongoing medical care will no longer result in an interest expense deduction.
Example: J and M made a $200,000 down payment and borrowed $600,000 to purchase a residence worth $800,000 in 2013. Their home is currently valued at $950,000 with an acquisition debt remaining of $500,000. In 2019, they borrow $200,000 to provide for the ongoing medical care of their 15-year-old son with special needs and use their residence to secure this note.
They may deduct interest on the $500,000 of remaining acquisition debt only and the $200,000 home equity loan if the loan was used 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). Barring a medical capital expenditure, a home equity loan's interest expense will not be deductible for ongoing medical care.
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 preretirement withdrawals (i.e., before age 59½), there are exceptions to the penalty for distributions not in excess of the medical expense deduction (This exception does not apply to distributions covered by certain other exceptions in Sec. 72(t)(2)).
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 10% of AGI as of 2019 (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 that is included in gross income. The income tax still applies to the taxable component of the distribution.
Individuals are not required to first deplete the 10% penalty exception for medical care by using the nontaxable component of a distribution, such as a nontaxable return of investment (Argyle, T.C. Memo, 2009-218). A properly completed Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, with an accompanying medical expense worksheet (or Schedule A, Itemized Deductions, for itemizers) must be attached to Form 1040, U.S. Individual Income Tax Return.
Example without itemizing deductions and claiming the standard deduction: Mr. and Mrs. T, both age 50, have an AGI of $35,000 for the year 2019, which includes an early retirement plan distribution. The Ts incur (and actually pay) $9,500 in qualifying medical expenses during the year. The allowable medical deduction will be the amount of medical expenses that exceeds 10% of $35,000 or $3,500. Although the Ts claim the standard deduction of $24,400 for 2019, their allowable medical expense deduction for 2019 would have been $6,000 ($9,500 in medical expenses less $3,500) 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 $6,000 would escape the 10% penalty. The balance of the distribution, $2,000 will be subject to a 10% penalty of $200.
Example when itemizing deductions: Mr. and Mrs. S, both age 50, have an AGI of $105,000 for the year 2019, which includes an early retirement plan distribution. The Ss incur (and actually pay) $26,000 in qualifying medical expenses during the year. The allowable medical deduction will be the amount of medical expenses that exceeds 10% of $105,000 or $10,500. Their allowable deduction for 2019 is $15,500 ($26,000 in medical expenses less $10,500). 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 $20,000, only $15,500 would escape the 10% penalty. The balance of the distribution, $4,500 will be subject to a 10% penalty of $450.
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. This has been exacerbated in 2019 by the increase in the AGI threshold for the medical expense deduction.
It should also be noted that for an IRA distribution, the law applies the medical expense exception before other exceptions; notably, the first-time homebuyer and education exceptions (Secs. 72(t)(2)(E) and (F)). As a result, families with significant unreimbursed medical expenses may wish to consider using the medical expense exception first for retirement plan distributions, availing themselves of the first-time homebuyer and educational exceptions under the IRA distribution rules (Blankenship, "Retirement Plans, IRAs, and Annuities: Avoiding the Early Distribution Penalty" 42 The Tax Adviser 260 (April 2011)).
Financing options for families
To help families finance the often large medical expenses that both parents and caregivers incur on behalf of individuals with special needs, it is important to understand the tax benefits and financing options that are available to those caring for these individuals.
Thomas M. Brinker Jr., CPA/PFS, CGMA, J.D., LL.M., ChFC, CFE, AEP, is professor of accounting at Arcadia University in Glenside, Pa. He also serves as director of the MassMutual Center for Special Needs Planning at The American College of Financial Services in Bryn Mawr, Pa. To comment on this article or to suggest an idea for another article, please contact Sally Schreiber, senior editor, at Sally.Schreiber@aicpa-cima.com.