Understanding the 2013 Medicare Tax
Presented by Christian Rezapour
In 2010, the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act were passed into law. One of their important provisions is a new Medicare tax designed to help pay the cost of health care reform. The new tax is effective in 2013, so it’s important to start planning now if you haven’t done so already.
What’s changing?
Medicare contribution tax. The 2.90-percent Medicare tax will continue to be applied to wages and net self-employment income. Half of the tax (1.45 percent) is picked up by the employer and the other half (1.45 percent) by the employee. Effective in 2013, an additional 0.90-percent tax will be levied on wages and self-employment income above certain thresholds.
Wages or net earnings above $200,000 (single), $250,000 (married), or $125,000 (married but filing separately) will be taxed at an overall rate of 3.80 percent. The 0.90-percent rate increase applies only to the employee’s (or self-employed taxpayer’s) share of the Medicare tax. Unlike the social security tax, which has a “wage base” ceiling, there is no compensation limit. Each dollar is subject to the Medicare tax.
Example: Tom earns $300,000 and Janet earns $150,000. Tom’s employer will withhold 0.90 percent (or $900) on the $100,000 earned in excess of $200,000. Janet’s employer will not withhold any additional Medicare tax. Rather, the additional Medicare tax will be computed based on the couple’s combined wages over the $250,000 threshold for married taxpayers (or $200,000), resulting in a tax of $1,800. This would leave them with an additional $900 tax when filing their return, over and above the $900 that Tom’s employer withheld.
Tax on investment income. Higher-income taxpayers will also be subject to a 3.80-percent tax on most net investment income over the thresholds, in addition to any other applicable tax. The exceptions are distributions from retirement accounts—including pensions, 401(k)s, and IRAs—and income generated from municipal bonds. Keep in mind, however, that distributions from retirement accounts can push your adjusted gross income over the threshold, thus subjecting you to a 3.80-percent tax on your other investment income.
The following types of investment income will be affected:
- Taxable interest
- Capital gains
- Dividends
- Nonqualified annuity distributions
- Royalties
- Rental income
In addition, the new Medicare tax on investments will affect homeowners with appreciation greater than $250,000 ($500,000 if married) on their personal residences. The new law will also apply to estates and most trusts. The threshold for estates and trusts is currently $11,950, the amount at which their highest tax bracket begins.
Calculating the tax
For individuals, the 3.80-percent Medicare tax is applied to the lesser of net investment income or the excess of modified adjusted gross income (MAGI) over the applicable threshold ($200,000 for single filers, $250,000 for married filers, and $125,000 for married filing separately).
Example: Mark and Sue have earnings from wages of $175,000 and investment earnings of $100,000. The couple’s total wages and investment earnings (MAGI) equal $275,000. According to the rule, the 3.80-percent Medicare tax will be applied to the lesser of net investment income ($100,000) or the excess of MAGI over the applicable threshold ($25,000). In Mark and Sue’s case, then, only $25,000 will be subject to the Medicare tax. The entire $100,000 in investment income will be subject to either capital gains or ordinary income tax, depending on the nature of the income.
How will the new Medicare tax affect you?
If you believe that your income tax rate will be higher in the future than it is today, you may want to consider taking some kind of action to minimize the impact. One possibility might be a Roth IRA.
Roth IRA conversions. Roth IRAs have become popular alternatives to traditional IRAs. Not only does money held in a Roth IRA grow tax-deferred for federal income tax purposes, but distributions are also tax-free if certain requirements are met. (Please note: State tax treatment of Roth IRAs differs. Consult your tax advisor about your state’s rules.) Another advantage is that no minimum distributions are required upon reaching age 70½. Thus, you may avoid having retirement distributions increase your adjusted gross income over the threshold and exposing other income to the new Medicare surtax.
If a Roth IRA makes overall financial sense for you, you can convert a traditional IRA to a Roth IRA. When you convert to a Roth IRA, you pay income tax on the taxable dollars that are converted. These taxes are due in full in the year of conversion. Paying taxes on the conversion today may allow future distributions to escape scheduled tax increases later. It is generally better to pay these taxes with funds from another account; using IRA assets will typically result in more taxes and may involve early withdrawal penalties, depending on your age.
For more information on how the new tax will impact you and your family, please speak with your financial advisor.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.
IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
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Christian Rezapour is a Financial Advisor at Wealthmark Financial Services which is located at 808 Valley Forge Rd, Suite 104, Phoenixville, PA 19460. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 610.400.1111 or at mailbox@wealthmark.net.
© 2013 Commonwealth Financial Network®
