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Friendly Reminder: Medicare Surtaxes Increase Taxes for Many

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Jan 7th 2015
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Two distinctly different Medicare surtaxes surfaced in 2013 and remain on the books. Both levies target higher-income individuals: One increases the tax on earnings, and the other increases the tax on investment income. The surtaxes are part of a comprehensive health care reform package enacted in 2010—known officially as the Patient Protection and Affordable Care Act of 2010 and the Health Care and Education Reconciliation Act of 2010, but more commonly referred to as Obamacare.

Surtax on earned income. The additional Medicare tax of 0.9 percent applies only to individuals with wages above the applicable thresholds—$250,000 for joint filers, $125,000 for married couples filing separate returns and $200,000 for single filers. Their employers pay nothing extra. The levy also applies to individuals with self-employment income above the thresholds.

Surtax on investment incomedrastically changes the rules. Before 2013, the Medicare payroll tax applied just to wages, not investment income. It now applies to certain kinds of investment income. The tax of 3.8 percent kicks in only when MAGI exceeds specified amounts. (MAGI is the same as AGI for almost all individuals except for expatriates, who must add back certain amounts that are excludable from U.S. income taxes.)

The 3.8 percent tax applies only to joint filers with MAGI above these thresholds—$250,000 for joint filers, $125,000 for married couples filing separate returns and $200,000 for single filers. Even then, it’s imposed on the smaller of a person’s net investment income or the amount by which MAGI exceeds the applicable threshold.

The legislation broadly defines income from investments. It includes interest, dividends, capital gains on the sales of investments like stocks and bonds, annuities, royalties, rents, and income from passive investments, in which a person puts money into a business but isn’t active in it.

It doesn’t include tax-exempt interest from municipal bonds or muni bond funds or withdrawals from retirement plans such as IRAs, Roths and 401(k)s, life-insurance proceeds payable at death, veterans’ benefits and income from businesses in which a person actively participates such as Subchapter S corporations or partnerships.

What the 3.8 percent tax accomplishes is to increase the top rate for long-term capital gains from 20 percent to 23.8 percent. (For most investors, 15 percent continues to be the top rate.) It doesn’t affect someone without investment income. Similarly, it doesn’t affect someone whose entire income is from investments, as long as the total investment income is under the MAGI thresholds.

How the surtax can affect you. When the surtax does apply, here’s how the numbers work: Suppose a couple filing jointly has investment income of $100,000 and MAGI of $300,000. Besides their regular income taxes, they have to pay a surtax of $1,900—3.8 percent on the $50,000 excess over $250,000. This is because their MAGI of $300,000 reduced by their $250,000 threshold amount is less than their investment income of $100,000.

For a single person with investment income of $100,000 and MAGI of $400,000, the surtax is $3,800—3.8 percent on the income of $100,000. This is because her investment income of $100,000 is less than her MAGI of $400,000 reduced by her $200,000 threshold amount.

More bad news. Investors must separately calculate the extra 0.9 percent wage-based tax and the 3.8 percent tax on investment income. Assume a single person has wages of $180,000, investment income of $60,000, and MAGI of $220,000. She escapes the 0.9 percent tax and is billed $760 for the 3.8 percent tax on $20,000 (MAGI of $220,000 minus threshold of $200,000).

What happens when she has earnings of $300,000, investment income of $60,000 and MAGI of $400,000? Her wages of $300,000 put her $100,000 above the threshold of $200,000, boosting her tax tab by $900 ($100,000 times 0.9). She’s also nicked for $2,280 (3.8 percent on the entire $60,000—the lesser of her investment income of $60,000 or the amount by which MAGI of $400,000 exceeds her threshold of $200,000). Her total increase is $3,180.

What’s ahead? With Washington’s cantankerous mood, it’s uncertain whether there’ll be further tax increases. What could happen is that President Obama and a Republican-controlled Congress cut deals for more changes like the Medicare surtaxes: a few percent here, a few percent there, rather than straightforward rate increases or decreases. What seems to be certain is that our lawmakers will enact even more complications to an already confusing tax code.

About the author:

Julian Block writes and practices law in Larchmont, New York, and was formerly with the IRS as a special agent (criminal investigator) and an attorney. More on this topic is available from “Julian Block’s Year Round Tax Strategies,” available at julianblocktaxexpert.com.

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