Regulating Health Insurance: State efforts to increase health coverage come with a price--higher income taxes

In an effort to increase health insurance coverage, many states, including Rhode Island, have passed laws to increase the maximum age limit for young adults to stay on their parents’ health insurance policies. According to the Associated Press (AP), seventeen states have passed such laws over the last two years, increasing the maximum coverage age for children anywhere from twenty-four year-old all the way up to thirty. (Here is a list of state coverage initiatives in this area.)

While most states still impose age limits that force dependents off of a parent's policy at age 19 for a nonstudent and 23 for a full-time college student, more states are considering raising the age. Why? According to the AP, more than 13 million Americans between 19 and 29 are uninsured. While critics refer to such laws as the “slacker mandates” and argue that they promote adverse selection and increase the price of insurance for everyone else, proponents of such laws are certainly correct that these laws, if widely adopted, will decrease the number of otherwise uninsured twentysomethings.

Whether you are in favor of these coverage mandates or not, there’s one hitch to such laws that isn’t often mentioned: the tax consequences for parents keeping their twentysomething children on the family's employer-based health insurance coverage.

Most people who have health insurance get it through their employer. One of the benefits of employer-based coverage is that federal tax law allows the value of the health insurance coverage for the employee, the employee’s spouse and the employee’s “qualifying” children to be excluded from the employee’s gross income. Currently, the Internal Revenue Code (IRC) provides that an individual must meet certain relationship, residency, and age requirements to be a “qualifying child.” Unless disabled, a child must not have reached the age of 19 or, if a student, 24 in order to meet the age requirement. Thus, there is a disparity between the age that some states allow a child to remain covered under a parent's health insurance policy and the age cap that the federal government imposes on a tax deduction for such coverage.

This disconnect between the IRC and the new state coverage laws has several important consequences for parents. First, when a parent elects health insurance coverage for his or her twenty-five year-old child under a state coverage mandate, the share of the premium for the child's coverage will be treated on a post-tax basis. Premiums treated on a post-tax basis are considered part of the employee's wages for federal tax purposes (and state income tax purposes, if applicable). In addition, standard deductions (e.g., the Social Security and Medicare taxes) will be taken. Second, any premium paid by the employer towards the health insurance coverage for the child will be imputed to the parent as income and, consequently, will be reported as taxable income. From this imputed income, standard deductions (federal and state income taxes, Social Security, Medicare, etc.) will also be taken. Finally, a parent will no longer be able to use pre-tax funds from a flexible spending account or health savings account to pay for that child’s health care.

Thus, parents who include their adult children in their employer-based health insurance under these new state laws need to understand that this expanded coverage comes with a price: a significant tax penalty—one that could reach into the thousands of dollars per year.