Start Planning Now: Medicare Tax Hikes Begin in 18 Months
Provisions Targeting "High-Income" Wage Earners
Taxpayers with substantially higher income should expect to pay more tax liability starting in 2013. The recent health care legislation that President Obama signed into law on March 23, 2010 contains over $400 billion in tax increases throughout the next decade. Individuals earning over $200,000 in wages and joint filers earning over $250,000 will be liable for the majority of this revenue. The two areas which will be affected the most for this group are Medicare Payroll Tax and liability on "un-earned" income.
Medicare Payroll Tax
Currently, the Medicare payroll tax is 2.90% -- with the employee and their employer each paying 1.45%. Under the new law, "high-income" individuals will pay an additional 0.90%; so their share will total 2.35% of their wages. This increase is only for the employee; the employer will not incur additional tax liabilities.
For wage earners, the law requires their employer to withhold the additional tax. If the employer fails to collect the tax, the employees will be liable for the tax on their return (and the employer will be liable for penalties). Also, for joint filers, the law does not require the employer to consolidate what the employee's spouse may earn - so, some married couples may be liable for additional payroll tax that is not satisfied by the withholding. For example, consider a husband and wife who earn $200,000 and $100,000 respectively. Neither is required to withhold additional funds as they are both under the threshold. However, when they file a joint return, their wages together would exceed the $250,000 threshold, subjecting $50,000 of wages to the new tax, which would amount to approx. $450.
Self-employed Individuals are also affected. If the self-employed individual also has wage income, then the threshold on which the additional tax is imposed is reduced by the amount of wages taken into account. For example, if the self-employed individual reports an income of $400,000 (filing single) and has wage income of $50,000, the threshold would be reduced from $200,000 to $150,000. Self-employed individuals are not permitted to deduct any portion of the additional tax.
Below is a table which illustrates how the new Medicare tax will affect a variety of high-income wage earners:
Single Taxpayer Joint Return
Earnings Additional Tax Additional tax
$250,000 $450 -
$500,000 $2,700 $2,250
$1,000,000 $7,200 $6,750
$5,000,000 $43,200 $42,750
Source: Deloitte "Tax provisions in the Patient Protection and Affordable Care Act" 2010
This new tax will apply to the following types of "unearned" income: interest, dividends, annuities, and rental income. Because the tax applies to "gross income," certain sources are excluded such as tax-exempt interest. Other types of exempted items would include dispositions of certain active partnerships and S corporations and distributions from qualified plans.
The tax will consist of a 3.8% surcharge on the lesser of a taxpayer's net investment income or the amount that the modified adjusted gross income exceeds the threshold ($200,000 for singles and $250,000 for joint filers). So, for example, if you are a married filer with $300,000 of modified adjusted gross income and your unearned income is $100,000, you would owe the 3.80% tax on the $50,000 which you were over the threshold.
The law defines modified adjusted gross income as AGI increased by any income excluded by the foreign earned income exclusion.
In dollars, how might a high-income person's tax bill increase as a result of these two new rule changes? According to Deloitte ("Prescription for Change 'filed' March 21, 2010), a single taxpayer earning $1 million in wages and $100,000 in capital gains income would pay an additional $11,000 more than he or she does today.
A strategy to avoid or reduce this additional tax would be to contribute the maximum amount permitted into your 401(k) or 403(b). In addition, you may want to consider altering your non-qualified investments to include more tax free instruments such as municipal bonds or stocks which do not pay dividends. Be sure to consult with your tax advisor before implementing any investment changes.
HORAN will continue to monitor developments and publish related communications as warranted. Please feel free to call on us to provide information you, your clients, and their trustees need to know regarding this issue.
Terence L. Horan, CLU, ChFC
Gregory L. Hoernschemeyer, CLU
Michael Napier, CFP