New Medicare Tax Takes Effect in 2013 – December 13, 2012 by Robert Venables

Starting in 2013, high-income taxpayers will face two new taxes—a 3.8% Medicare contribution tax on net investment income and a 0.9% additional Medicare tax on wage and self-employment income. Here's an overview of the two new taxes and what they may mean to you.

3.8% Medicare Contribution Tax
This new tax will only affect taxpayers whose adjusted gross income (AGI) exceeds $250,000 for joint filers, $200,000 for single taxpayers and $125,000 for married filing separately. These threshold amounts aren't indexed for inflation. Thus, as time goes by, inflation will cause more taxpayers to become subject to the 3.8% tax.

If AGI is above the threshold, the 3.8% tax will apply to the lesser of (1) net investment income for the tax year or (2) the excess of AGI for the tax year over the threshold amount. This tax will be in addition to the income tax that applies to that same income. The Medicare contribution tax must be included in any estimated tax calculation.

The tax also applies to estates and trusts, but with different threshold amounts that start at $11,350 (this amount is based on the 2011 tax schedule and may increase slightly for 2013).

Net Investment Income
The “net investment income” that is subject to the 3.8% tax broadly consists of interest, dividends, annuities, royalties, rents and net gains from property sales. Passive business income is subject to the Medicare contribution tax. Income from a business of trading financial instruments or commodities is also included in net investment income.

Wage income is excluded from net investment income as is most income from an active trade or business. Income that is exempt from income tax, such as tax-exempt bond interest, is likewise exempt from the 3.8% Medicare contribution tax. Thus, switching some taxable investments into tax-exempt bonds could impact exposure to the 3.8% tax. Of course, this should only be done with due regard to income needs and investment considerations.

Home Sales
As mentioned, the 3.8% tax applies to home sales. If the sale relates to a primary residence, the taxpayer may be able to exclude up to $250,000 of gain, or up to $500,000 for joint filers, when figuring income tax. This excluded gain won't be subject to the 3.8% Medicare contribution tax. However, gain that exceeds the limit on the exclusion will be subject to the tax. Gain from the sale of a vacation home or other second residence, which doesn't qualify for the income tax exclusion, also will be subject to the Medicare contribution tax.

Retirement Plan Distributions
Distributions from qualified retirement plans, such as pension plans and IRAs, aren't subject to the Medicare contribution tax. However, such distributions may push AGI over the threshold that would cause other types of investment income to be subject to the tax. Qualified Roth IRA distributions are neither subject to the Medicare contribution tax nor included in AGI. Distributions from traditional IRAs will be included in AGI, except to the extent of after-tax contributions, although they won't be subject to the Medicare contribution tax.

Additional 0.9% Medicare Tax
Starting in 2013, some high-wage earners will pay an extra 0.9% Medicare tax on a portion of their wage income, in addition to the 1.45% Medicare tax that all wage earners pay. The 0.9% tax applies to wages in excess of $250,000 for joint filers, $125,000 for married individuals filing separately and $200,000 for all others. The 0.9% tax applies only to employees and is not matched by employers. While the tax burden clearly rests on the employee, once an employee's wages reach $200,000 for the year, the employer must begin withholding the additional 0.9% tax from the wages. There may be situations in which the employer is not required to withhold the additional tax but the employee is subject to it. In such cases, the employee would pay the additional tax on his or her income tax return.

Self-Employment Tax
An extra 0.9% Medicare tax also applies to self-employment income for the tax year in excess of $250,000 for joint filers, $125,000 for married individuals filing separately and $200,000 for all others. This 0.9% tax is in addition to the regular 2.9% Medicare tax on all self-employment income. While self-employed individuals can claim half of the self-employment tax as an income tax deduction, the additional 0.9% tax won't generate any income tax deduction.

There are many nuances surrounding these taxes that have yet to be finalized. The IRS recently issued proposed regulations related to some of these issues, and we will keep you informed as the details are finalized. In the meantime, please talk to your tax advisor to digest the larger picture as it relates to your specific tax situation.

For additional information, please contact Robert Venables.

 

This communication is for information only, and any action should only be taken after a detailed review of the specific situation and appropriate consultation.

Notwithstanding that these materials do not constitute legal, accounting or other professional advice, as may be required by United States Treasury Regulations and IRS Circular 230, you should be advised that these materials are not intended or written to be used, and cannot be used by you or any other person, for the purpose of avoiding penalties that may be imposed under federal tax laws. No written statement contained in these materials may be used by any person to support the promotion or marketing of or to recommend any federal tax transaction(s) or matter(s) addressed in these materials, and any taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor with respect to any such federal tax transaction matter.