Medical insurance reimbursement shows up on next year's return

We took a deduction for medical expenses on our
1997 tax return. This Spring we received a medical insurance reimbursement and
part of the money we received was for medical expenses we deducted. Should we
amend last year's tax return?

L.S., Zionsville

You don't have to amend your 1997 tax return, leave it filed as is. However, you're not completely off the hook.

Your insurance reimbursement may have to be included as income on your 1998 tax return, which you will file next spring. The reimbursement is considered taxable income to the extent that your 1997 tax was reduced as a result of the amount of the reimbursement.

Here's how it works:

Suppose your 1997 tax return included $5,900 in medical expenses on Schedule A, $1,000 of which was deductible (remember, you can only deduct medical expenses to the extent that they exceed 7.5% of your adjusted gross income, or, in this case, $4,900).

In the Spring of 1998, you receive $1,500 from medical insurance which relates to medical expenses that were included on your 1997 tax return. Your 1997 income tax was reduced as a result of some medical expenses. But how much of the reimbursement do you add back to income, the full $1,500?

Not quite. Had you received that reimbursement in 1997, the same year in which the expenses were incurred, you would have reduced your 1997 medical expenses by $1,500, leaving you with $4,400 in medical expenses. Because you needed $4,900 in medical expenses to generate a deduction for 1997, you would not have been able to deduct any medical expenses in 1997.

Your 1998 tax return should show $1,000 in income as a result of your insurance reimbursement. Only $1,000 of your 1997 medical expenses were used as part of your itemized deductions, the rest of your medical expenses were disallowed as a result of the 7.5% of AGI limitation. Therefore, only $1,000 of the insurance reimbursement needs to be added back into income.

One more thing to consider: suppose your total 1997 itemized deductions (including the $1,000 allowed as a medical deduction) added up to $7,500. As a married couple filing jointly, you could have taken a standard deduction of $6,900 for 1997. The standard deduction is available to all taxpayers, as an alternative to itemizing. Instead you took the greater deduction, the itemized deductions of $7,500.

Your itemized deductions exceeded the standard deduction by $600 ($7,500 deductions less $6,900 standard deduction). So actually, you only saw a benefit of $600 from your itemized deductions. In this situation, you would only need to add $600 of your medical insurance reimbursement to your 1998 income.

If you took a standard deduction in 1997 and didn't itemize, none of the insurance reimbursement is taxable in 1998.

Once you determine how much (if any) medical insurance reimbursement needs to be claimed as income in 1998, you should include that amount on the front page of your 1040 (in this situation you can't use Form 1040A or Form 1040EZ), on the line called Other Income. The description of the income should be something like, "1997 Itemized Deductions Recovered" or "Taxable Insurance Reimbursement." You do not need to attach a copy of your 1997 tax return.

It wouldn't hurt to attach a little statement to the back of your tax return showing how you came up with the amount you are including in income. The statement could look something like this:

(a) 1997 medical insurance reimbursement received in 1998 $1,500

(b) 1997 medical expenses allowed $1,000

smaller of (a) and (b) to Form 1040, Page 1, Line 21 $1,000

Whenever you attach a statement to your tax return, make sure your name and social security number appear on the top of the statement. This way the IRS will know what to do with the statement if it gets separated from the rest of your tax return.

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