Medicare Hospital Insurance TaxMedicare taxes are imposed at a flat tax rate of 2.9% on wages, salaries, and business or farming income earned by self-employed individuals. There's no limit on the amount wages subject to Medicare taxes, unlike the annual wage limit for Social Security taxes.
The medicare hospital insurance tax is paid half by employees through payroll deductions and half by the employer. Accordingly, employees pay a Medicare tax rate of 1.45% (half of the 2.9% rate).
Self-employed persons pay both halves of the Medicare tax since they are both the employee and the employer. However, self-employed persons are allowed to deduct half of the Medicare tax as an adjustment to income. Self-employed persons calculate and pay their Medicare tax when filing their personal tax return as part of the self-employment tax.
Additional Medicare Taxes for 2013 and BeyondStarting in the year 2013, the Medicare tax will be expanded. The tax rate will be increased for higher-income individuals, and the income subject to the Medicare tax will be expanded to include investment income. Technically, this additional tax is called the unearned income Medicare contribution tax, and was enacted as part of the health care reform laws.
Calculating the Unearned Income Medicare Contribution TaxThe unearned income Medicare contribution tax is an additional tax of 3.8%. This tax is in addition to any regular income taxes. The tax is calculated by multiplying the 3.8% tax rate by the lower of the following two amounts:
- net investment income for the year; or
- modified adjusted gross income over a certain threshold amount.
Net investment income for the purposes of calculating the unearned income Medicare contribution tax includes interest, dividends, capital gains, annuities, royalties, rents, and pass-through income from an passive business such as S-corporations and partnerships.
The following types of income will not be subject to this additional Medicare tax: tax-exempt municipal bond interest, nontaxable veteran's benefits, capital gains excluded from the sale of a principal residence, and distributions from IRAs, 403(b) plans, 401(k) plans, 457 plans, pensions, profit-sharing plans, stock bonus plans, or qualified annuity plans.
Modified adjusted gross income for the purpose of calculating the additional Medicare tax is a person's adjusted gross income with the foreign earned income exclusion or foreign housing exclusion added back in.
Modified adjusted gross income thresholds for the additional Medicare tax are:
- $250,000 for married filing joint filers and qualifying widows or widowers;
- $200,000 for single and head of household filers; and
- $125,000 for married filing separately filers.
Sample calculation: Suppose Fred and Wilma are married and file a joint tax return. They have $260,000 of salary income combined and $50,000 of investment income from dividends and capital gains. Their adjusted gross income is $310,000. They don't have any foreign income exclusions.
- Step 1: Calculate their net investment income, or $50,000.
- Step 2: Calculate their modified adjusted gross income in excess of the threshold amount, or 310,000 minus 250,000 for joint filers = $60,000.
- Step 3: Take the lower of net investment income or modified adjusted gross income over the threshold, which is $50,000 in this case.
- Step 4: Multiply 50,000 by 3.8% = $1,900.
Payroll Withholding Authorized in Anticipation of the Additional Medicare TaxEmployers are required to withhold an additional 0.9% on employee's wages in excess of the threshold amounts. This additional 0.9% rate is the difference between the 3.8% unearned income Medicare contribution tax rate and the 2.9% regular Medicare hospital insurance tax rate. However, the unearned income Medicare contribution tax rate is a tax imposed on individuals, and so no deduction is allowed for employers or self-employed persons for this additional Medicare tax. Also, employers might not always know if an employee is subject to this additional Medicare tax. The additional Medicare tax will be calculated on an individual's personal income tax return, and any shortfall not covered by withholding will need to be paid by the individual. Employers, however, may be subject to penalties and interest for not withholding the additional Medicare tax.
Planning Ahead for the Unearned Income Medicare Contribution TaxThe additional Medicare tax takes effect starting in the year 2013. Higher-income individuals will want to do some quick math to see how this tax will impact their finances. Some tax planning suggestions:
- Shift income-producing investments into tax-deferred plans such as IRAs and 401(k) accounts.
- Consider tax-exempt bonds instead of taxable bonds. (Suggested by Tony Nitti.)
- Pair capital gains with capital losses so that net capital gains are as low as possible.
- Defer selling investments with a capital gain to a year when the additional Medicare tax would not apply.
- Give income-producing investments to children or other family members who aren't subject to the additional Medicare tax. (Suggested by Rick Bailine.)
- Manage your modified adjusted gross income around the thresholds for the Unearned Income Medicare tax. (Suggested by Tony Nitti.)
- Harvest investment gains, but not losses, prior to the end of 2012. (Suggested by Tony Nitti.)
- Consider meeting the material participation test for income generated by an S corporation or partnership. (Suggested by Tony Nitti.)
- Consider meeting the real estate professional test for income generated by rental properties. (Suggested by Tony Nitti.)
- Increase payroll withholding or estimated taxes to cover the additional Medicare tax.
- Internal Revenue Code sections 1401, 1411 and 3101.
- Tony Nitti, "Five Tax Planning Strategies For Minimizing The Additional 3.8% Obamacare Tax On Investment Income," Forbes, November 19, 2012, accessed November 19, 2012, http://www.forbes.com/sites/anthonynitti/2012/11/19/five-tax-planning-strategies-for-minimizing-the-additional-3-8-obamacare-tax-on-investment-income/. (Summarized here.)
- Rick Bailine as quoted in Roger Russell, "Guessing at the Law: Unprecendented levels of uncertainty wreak havoc on year-end planning," AccountingToday, September 1, 2012, accessed November 19, 2012, http://www.accountingtoday.com/ato_issues/26_9/Guessing-at-the-law-63788-1.html. (Summarized here.)