The Medical Tax Credit

In order to understand the benefits of an HSA versus the traditional Medical Tax Credit, I thought it would be valuable to provide some basic information on the credit.  If you own a company, you pay yourself (and your employees if applicable) a salary for the work performed.  This salary is subject to source deductions like CPP, EI, and income tax.  What you have left, you use to finance your lifestyle and in many cases, pay for insurance premiums or out-of-pocket health expenses such as dental bills, prescriptions, or elective surgery.  At the end of the year, you can declare these expenses on your annual tax return and apply for the medical tax credit.  The medical tax credit is a non-refundable tax credit, meaning that it can only be used to reduce federal or provincial/territorial taxes to zero.

Taxpayer and Immediate Dependents

Medical expenses for the taxpayer, their spouse or common-law partner, and dependent children under 18 are claimed on line 330 of the federal tax return.  Only expenses greater than the lesser of $1,925 or 3% of net income can be claimed. The lowest tax rate is applied to the medical expenses to determine the amount of the tax credit you will receive.  

“Other” Dependents

Medical expenses for other eligible dependents are claimed on line 331 and a separate calculation is done for each dependent. Only expenses greater than the lesser of $1,925 or 3% of net income of the dependent can be claimed, up to a maximum of $10,000 per dependent. The lowest tax rate is applied to the medical expenses to determine the amount of the tax credit you will receive.

The key difference between the HSA and the medical tax credit is that the HSA is a full-deduction for the business and 100% tax-free for the recipient (i.e. the employee).  There are no thresholds for deduction by the company and the employee does not declare the deposits into the HSA as the amount is not considered to be income.  The amount spent from the HSA on eligible medical expenses represents a true dollar value in tax-free benefit for the employee versus the amount received from the medical tax credit, which is only a portion of the actual cost.  However, it is important to note that the HSA does not reduce overall personal income tax like the medical tax credit – unless it is paid in lieu of a portion of the employee’s normal salary.  For example, if the employee earned $100,000 in 2007, the source deductions would reflect the amount owed based on $100,000.   However if the employee’s compensation changed in 2008 to be $80,000 and the company deposited $20,000 into an HSA, then the source deductions would be reduced to reflect the amount owed on $80,000 as the $20,000 HSA contribution would be a tax-free benefit.