With all of the talk about the so-called “fiscal cliff,” many people have forgotten about the Medicare surtaxes that have gone into effect. These taxes are part of the Patient Protection and Affordable Care Act (as amended by the Health Care and Education Reconciliation Act of 2010) and affect income tax returns for individuals, trusts and estates for tax years beginning on, or after, Jan. 1, 2013.
The first Medicare surtax is a payroll tax increase on earned income above certain thresholds. Earned income includes wages, self-employment income, commissions, bonuses and tips, but excludes investment income. The Medicare payroll tax was 2.9 percent — of which the employer is responsible for 1.45 percent. The other 1.45 percent is your responsibility and should be automatically deducted from your paycheck. Under the new tax provision, there’s an additional 0.9 percent tax on the amount by which an individual’s earned income exceeds $200,000 for individuals, $250,000 for couples filing jointly or $125,000 for spouses filing separately.
At the point when an employee’s wages reach $200,000 for the year, the employer must begin withholding the additional 0 .9 percent. Keep in mind, however, the additional withholding might not be sufficient since it doesn’t account for wages earned from other employers (including self-employment income) or a spouse during the year.
Here is an example: Taxpayer and spouse file jointly. Taxpayer has $225,000 in wages and spouse has $75,000 in self-employment income. Taxpayer’s employer will withhold the additional 0.9 percent on $25,000 of the taxpayer’s wages. However, since the couple filing jointly will exceed the $250,000 threshold, the two are liable for additional Medicare tax on another $25,000 of earned income, for a total of $50,000 subject to the additional tax.
If you anticipate a liability related to this additional Medicare tax, you can request additional withholding through your employer using Form W-4 or you can make (or increase) quarterly estimated tax payments. You also might want to consider maximizing contributions to such pretax retirement plans as 401(k)s or 403(b)s since this will decrease the income subject to the Medicare surtax.
The second Medicare surtax is called the net investment income tax and imposes a 3.8 percent tax on certain net investment income of individuals, trusts and estates. The surtax will be applied to the lesser of net investment income or the excess of modified adjusted gross income (MAGI) over the same threshold amounts already noted. Net investment income includes taxable interest, dividends, nonqualified annuities, rents, royalties, the taxable portion of the gain on the sale of a personal residence, gains on the sale of investment property (including gains from the sale of a second home not considered a primary residence) and gross income from a passive activity. MAGI includes, but is not limited to, investment income, earned income and such additional taxable income as traditional IRA, 401(k) and qualified plan distributions as well as foreign earned income.
Here is an example: A taxpayer filing singly has $190,000 of wages and $80,000 income from taxable interest and dividends for a total MAGI of $270,000. Taxpayer’s MAGI exceeds the $200,000 threshold for single taxpayers by $70,000 and net investment income is $80,000. The surtax will be applied to the lesser of the two and the taxpayer will owe $2,660 of net investment income tax (3.8 percent of $70,000).
There are a few ways to reduce your exposure to the net investment income tax, including shifting investments from those with taxable earnings to tax- exempt municipal bonds. If you were on your toes in 2012, you might have accelerated some capital gains prior to 2013. You may still harvest losses in your portfolio to use in 2013 and beyond to offset gains. If possible, you could consider increasing your participation in passive activities to turn passive income into non-passive income.
Be warned, though, that the preamble to the regulations state the IRS will closely review transactions that appear to manipulate net investment income to reduce or eliminate the amount of tax due under these regulations. If deemed necessary, the IRS could challenge such transactions according to applicable statues and judicial doctrines.
While we won’t see the effect of these taxes quite yet, it’s a good time to begin planning for them. To review your specific circumstances and discuss your options and planning strategy, consult with a qualified certified public accountant.