While lawmakers continue to work out the details of the federal income tax rules for 2013 and beyond, there is one tax that we know for sure will be increasing on January 1, 2013. The new health care reform law raises payroll taxes beginning next year.
An additional 0.9 percent Medicare tax is imposed on wages, compensation and self-employment earnings above a threshold amount, starting January 1, 2013. Once the threshold is reached, the tax applies to all wages that are currently subject to Medicare Tax, to the Railroad Retirement Tax Act or to the Self-Employment Compensation Act.
Filing Threshold Is Not Same as Withholding Threshold
The 0.9 percent surcharge, unlike the existing Medicare tax, is imposed only on the employee. There is never a matching payment required by the employer. What's more, the employer's obligation to withhold is triggered without regard to whether the employee will, in fact, be liable for the tax.
Mark received $180,000 in wages through November 30, 2013. On December 1, 2013, Mark's employer paid him a bonus of $50,000. Prior to December 1, the employer was not required to withhold the Medicare tax surcharge. On December 1, Mark's employer is required to withhold Additional Medicare Tax on $30,000 of the $50,000 bonus. The employer may not withhold Additional Medicare Tax on the other $20,000. Mark's employer also must withhold the additional 0.9 percent Medicare tax on any other wages paid in December 2013.
If you have tipped employees, provide taxable fringe benefits, operate your business through more than one entity, or any other non-standard compensation arrangements, you should read the IRS Questions and Answers for the Additional Medicare Tax
Beware: Liability and Withholding Might Not Match Up
The fact that the withholding is triggered at $200,000 per employee per employer, while the tax liability threshold is based on filing status and combined earnings, can create over- or under-withholding issues. The following examples illustrate situations that can create problems.
Example 1: Bob, a single individual, earned $50,000 from an employer in 2013. He also had $200,000 in self-employment income for the year. Bob will be under-withheld because the $200,000 withholding income was not reached.
Example 2. Joyce earns $130,000 from her employer. Her husband Brian earned $100,000 from one employer and $60,000 from another employer during 2013. Their combined earnings are $290,000, which is $40,000 over the married, filing jointly threshold. However, none of their employers was required to withhold because neither of them earned over $200,000 from any one employer.
Example 3. Jim earns $220,000. He is married, but his wife does not have any earned income. Jim's employer must start withholding the additional 0.9 percent Medicare tax when Jim's earnings exceed $200,000. Jim will be over-withheld because the couple's combined income is beneath the married, filing jointly threshold.
These examples illustrate the importance of monitoring your tax situation. If you have earnings from multiple sources or if your spouse has a significant amount of earnings, you may find that you will owe tax, but your employer isn't required to withhold any amounts from our pay. In that case, you may want to request additional income tax withholding using Form W-4, Employee's Withholding Allowance Certificate. You should investigate whether you need make estimated tax payments for the year.
Three-Step Computation Needed for Wages plus Self-Employment Income
As the examples above indicate, there is one filing threshold per tax return and it applies to the aggregate amount of wages and compensation
paid by employers and self-employment income. However, because two separate employment tax systems (Federal Insurance Contributions Act (FICA) and Self-Employment Contributions Act) are involved, the computation is not as simple as adding all the amounts up and comparing that result to the threshold. No, if there is both FICA and SECA income, you must follow a three-step process to determine the amount of tax that you owe.
Step 1: Calculate Additional Medicare Tax on any wages in excess of the applicable threshold for the filing status, without regard to whether any tax was withheld.
Step 2: Reduce the applicable threshold for the filing status by the total amount of Medicare wages received -- but not below zero.
Step 3: Calculate Additional Medicare Tax on any self-employment income in excess of the reduced threshold.
The following examples help make this three-step process more understandable.
Example 1: Carlos, who is unmarried, has $130,000 in wages and $145,000 in self-employment income.
Calculate Medicare surtax due on wages. Since Carlos's wages are not in excess of the $200,000 threshold for single filers, he is not liable for the Medicare surcharge based solely on his wages. Also, his employer is not required to withhold any amounts for the 0.9 percent surtax.
Reduction of the filing threshold. Although his wages alone are insufficient to trigger the 0.9 percent surtax, he still must determine if his combined wages and self-employment income expose him to liability. However, before calculating the Additional Medicare Tax on self-employment income, the $200,000 threshold for single filers must be reduced by Carlos's wage income ($130,000). This results in a self-employment income threshold of $70,000.
Determine additional Medicare tax on self-employment income. To make this calculation, Carlos subtracts the reduced threshold amount ($70,000 in this case) from his total self-employment income of $145,000. Therefore, Carlos must pay the 0.9 percent surtax on $75,000 of self-employment income ($145,000 in self-employment income minus the reduced threshold of $70,000).
Example 2: Fran, who is married but files separately, has $175,000 in wages and $50,000 in self-employment income.
Calculate Medicare surtax due on wages. Fran is liable for the additional Medicare tax on $50,000 of her wages ($175,000 minus the $125,000 threshold for married persons who file separately). Although her wage income exceeds the liability threshold, it is does not exceed the withholding threshold, so her employer will not withhold any additional Medicare tax from her wages.
Reduction of the filing threshold. The $125,000 threshold for married persons who file separately must be reduced by Fran's wage income. However, it can not be reduced below zero.
Determine additional Medicare tax on self-employment income. Because the threshold is now reduced to $0, Fran must pay additional Medicare tax on the full amount ($50,000) of her self-employment income ($50,000 in self-employment income minus the reduced threshold of $0). In total, Fran owes additional Medicare tax on $100,000 ($50,000 of her wages and $50,000 of her self-employment income).
Take Action to Reduce Your Medicare Surtax Liability
If you are able to lower your taxable earnings, you will be able to reduce (or even eliminate) your exposure to the 0.9 percent Medicare surtax. One excellent technique would be to divert income into qualified retirement plan. Another strategy available to those who operate their business as an LLC or as a corporation is to characterize payments as a combination of both income and dividends. For more information on these techniques, see our article, Act Now to Minimize Impact of Increased Medicare Tax on Wages .