THE NEW TAX TWINS: 2013’s Medicare Nightmares

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The contentious Patient Protection and Affordable Care Act (“Obamacare”) has brought the typical discussion, debate, and arguments all new tax acts bring. And, while the Obama Administration recently delayed the mandate requiring businesses with 50 or more workers to provide health insurance to full-time employees, everything else is still active and ticking. So, while larger businesses are trying to craft a work-around for this mandate, many small business owners and high-income individuals must get set to face a set of taxes destined to create headaches and anger.

The two new Medicare surtaxes that have gone into effect are the 3.8% tax on unearned income and the .9% tax on earned income. We’ll take a quick look at these two sleeping giants.

3.8% Medicare Tax on Net Investment Income

This tax is remarkably easy to explain; that’s the good news. So what’s the bad news? It is onerous and will grab significantly more taxpayers than its less evil twin. Getting the technical definition out of the way first, individual taxpayers who earn more than $200,000 ($250,000 for married taxpayers filing jointly) face an additional 3.8% Medicare tax on the lesser of:

  1. their income in excess of $200,000 (or $250,000), or
  2. their net investment income (interest, dividends, royalties, rents, etc.).

So, let’s break this down a bit.

First, it is important to know that the $200,000 and $250,000 income levels above refer to your gross income from all sources. This would include your wages, interest and dividend income, self-employment income, rentals, royalties…you get the idea. So, if your total income exceeds these levels, congratulations, you fall victim to this tax.

The second important definition is what actually makes up your net investment income. Basically, it is anything you don’t directly earn (which is why many call it a tax on unearned income). Unearned income includes interest, dividends, rents, royalties, capital gains, and income from passive investments (i.e. K-1s you receive in which you do not actively participate). Unearned income does not include wages, social security benefits, unemployment income, alimony, tax-exempt interest, self-employment income, and income from businesses in which you actively participate. Calculating this tax is a bit more complicated, but we’ll try to make it as simple as possible.

Assuming you’ve passed the first test, the gross income test, you now will compare two totals: 1) the excess of your total income over the threshold amount (either $200,000 or $250,000), and 2) your gross unearned income. Once you have these two totals, multiply the lesser of these two amounts by 3.8%, and that’s the additional Medicare tax you owe. A couple of quick examples will be helpful:

  • Assume Joe and Maude have total gross income of $400,000, which includes $75,000 of interest and dividend income. Their gross income is over the married filing jointly threshold of $250,000 by $150,000 and their unearned income is $75,000. Because the lesser of these two figures is the $75,000 unearned income figure, they would multiply $75,000 by 3.8%, and would owe an additional $2,850 in Medicare tax.
  • Now, let’s assume Joe and Maude have total gross income of $400,000, which includes $325,000 of wages, $50,000 of tax-exempt interest, and $50,000 from a business that Maude operates. As in the example above, their gross income is over the married filing jointly threshold of $250,000 by $150,000, but their unearned income is $0. Why? Because, tax-exempt interest and self-employment income are not included in the definition of unearned income. So, Joe and Maude would owe $0 additional Medicare tax.

Be aware of this and plan for it. There are no withholding options available for this particular tax, so you’ll have to make this with additional estimates, additional withholdings, or pay it as a balance due with your tax return. For more information, check out what the IRS has to say.

.9% Medicare Tax

The .9% 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 (which is considered unearned income). The Medicare payroll tax that has been in place for years has amounted to 2.9% of all wages earned — of which the employer is responsible for half (1.45%), and the employee is responsible for half (1.45%). For almost everybody, this will remain the amount of Medicare tax you will pay. However, the Act now has a new provision for high-income earners: there’s an additional 0.9 percent tax on the amount by which an individual’s earned income exceeds $200,000 if you’re a single tax filer, $250,000 for couples filing jointly or $125,000 for spouses filing separately. Again, while this may not affect many of you, who’s to say that Congress won’t reduce these thresholds in the future to grab more of us and support their never-ending spending habit.

So, effective January 1, 2013, at the point when an employee’s wages reach $200,000 for the year, the employer must begin withholding the additional 0 .9% Medicare tax. While the onus is on the employer to withhold, it doesn’t relieve the taxpayer of the liability if the employer doesn’t. So, if you know your wages will exceed $200K this year, pay attention to the Medicare withholding when you approach the number. 

OK, so that said, here’s a warning! The additional withholding still might not cover your tax liability since it doesn’t account for wages earned from other employers (including self-employment income) or a spouse during the year. 

  • Consider this example: Joe and Maude file jointly.  Maude has $225,000 in wages and Joe has $75,000 in self-employment income. Maude’s employer withholds the additional 0.9 percent on $25,000 of her wages (the excess over $200,000). However, since the couple is filing jointly and their total earned income will exceed the $250,000 threshold, they are liable for additional Medicare tax on $50,000, not just on the $25,000 from Maude’s wages ($300,000 total earned income less the threshold amount of $250,000 for couples filing jointly).

The point to be made here is that once an employee reaches the $200,000 mark in earned income (remember, that is wages, self-employment income, commissions, bonuses and tips), the employer is required to begin withholding the additional .9% Medicare surtax regardless whether the taxpayers ultimately owe the tax or not. And yes, true to form, there is a scenario where one spouse is over the $200K threshold, but they won’t owe any additional Medicare tax. So, let’s use the Joe and Maude example again, but let’s change it up a bit. Joe and Maude file jointly.  Maude has $225,000 in wages and Joe has no self-employment income. Maude’s employer still withholds the additional 0.9% on $25,000 of her wages (the excess over $200,000). But, when Joe and Maude file their tax return, their total combined earned income does NOT exceed the $250,000 threshold for liability under the new .9% Medicare surtax (Maude’s $225,000 is the only earned income on their joint tax return). So, what happens now? When Joe and Maude file their income tax return, they will receive a credit for the additional Medicare tax withheld on Maude’s wages.

The bottom line here…if you know you’re going to approach these threshold amounts, be aware of it and make sure your employer is aware of it. The IRS has an extensive Q&A to aid taxpayers with these new Medicare taxes.

Rob Shaff

DISCLAIMER: This article is for informational purposes only and does not constitute tax or legal advice. If you want tax or legal advice, please contact a qualified tax professional or attorney.