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The increase in and expansion of the Medicare tax commenced January 1, 2013. The increase in the Medicare tax, as required under healthcare reform, has two significant components. The first component is an increase in the Medicare tax rate by 0.9%. This increase will be imposed on wages and self-employment income in excess of $200,000 for single persons and in excess of $250,000 for married couples filing jointly. The second component applies a new 3.8% Medicare tax to “Net Investment Income” when modified adjusted gross income is in excess of the $200,000 and $250,000 threshold amounts for single and married couples, respectively. Previously Medicare taxes only applied to wages and self-employment income and never to investment income.
There are lots of discussions coming out of Washington about simplifying the tax code. While, this sounds wonderful, the realities are the opposite. Beginning January 1, 2013 the tax code became significantly more complicated with these new taxes. The federal tax code already required taxpayers to go through two layers of tax computation, the regular income tax and the Alternative Minimum Tax. Calculating the Medicare tax on net investment income is an entirely new calculation that will be required by taxpayers. The IRS's proposed regulations related to this new tax exceed 140 pages. Include state income tax regimes, and many taxpayers will now have to calculate their income tax obligation under four separate regimes to determine their annual income tax liability. This certainly does not sound simple to me.
Some thoughts on the increase in the Medicare tax rate to wages:
• The highest marginal Medicare tax rate will be 2.35%, or 3.8% for self-employed persons.
• For married couples, wages are combined to determine if the additional surcharge is applied. For example, if a husband makes $175,000 and a wife makes $100,000, the additional Medicare surcharge will apply to $25,000 of the wages.
• Employers are required to withhold the additional 0.9% from an employee’s payroll when said employee’s salary exceeds $200,000. The employer does not have to determine wages earned by the employee’s spouse or from other jobs that the employee may have. As such, the tax witholdings will not likely match the amount of tax due. This may require taxpayers to make estimated tax payments.
• There is no additional payroll tax being assessed against the employer. All of the additional Medicare taxes under the law are paid by the employee.
• The new Medicare
tax will not be reduced by one-half for self-employed persons.
• The wage thresholds of $200,000 and $250,000 are not inflation adjusted. As such, this law will apply to more and more taxpayers over the years.
• The tax revenue generated by the tax will be sent to the general fund, not to the Medicare trust fund.
Some thoughts on the application of 3.8% Medicare tax that applies to net investment income:
• The tax applies to the lesser of the taxpayer's net investment income or the excess of the taxpayers modified adjusted gross income over the threshold of $200,000 and $250,000, respectively. As an example, if a taxpayer has wages of $300,000 and interest income of $10,000, the Medicare tax will apply to the $10,000 of investment income.
• Net investment income includes income from interest, dividends, royalties, rents. annuities, income from a business that is a passive activity.
• Gains from the sale of property are included in the calculation of net investment income, unless the property was held by the taxpayer in a business where he or she materially participated. As such, capital gains from a brokerage account will likely be subject to the Medicare tax, but capital gains from the sale of a small business that you owned would not be subject to the Medicare tax.
• One of the few exceptions to the Medicare tax on net investment income will be on S-Corporation income, where the taxpayer has “active” participation. It appears that the IRS is taking the position that these earnings will NOT be included in the calculation of net investment income. Consequently, they will escape both self-employment taxes as well as the Medicare tax on net investment income. (Note this is not the S corporation owners wages, but the profits / dividends allocated to the partner on the form K-1.)
• Tax free municipal bond interest will not be included in the calculation of net investment income. With the new maximum tax rate at 39.6% and the additional 3.8% Medicare charge on top of that, these instruments have even greater benefits to high income tax payers.
• Income from all types of traditional tax qualified retirement plans will not be included in the calculation of net investment income and thus not be subject to the tax.
As it currently stands, much of the regulations from the IRS are still in draft format. So the rule writing process is still fluid. Additionally, there will be positions taken by the IRS that will be challenged in the court systems.