Updated: Nov 14, 2018
As a result of the 2010 Affordable Care Act, the Medicare contribution tax has increased for high earners. How could the Medicare tax affect you?
The Medicare contribution tax
The 2.90-percent Medicare tax continues 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. An additional 0.90-percent tax, made effective in 2013, is now 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 now 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.
Tax on investment income
The 3.80-percent Medicare tax also applies to most net investment income. It is applied to the lesser of net investment income or the excess of modified adjusted gross income (MAGI) over the applicable threshold. 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 are affected:
Nonqualified annuity distributions
Personal residences with appreciation greater than $250,000 ($500,000 if married)
The law also applies to estates and most trusts. The threshold for estates and trusts is currently $12,400, 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 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 can you plan around the Medicare tax?
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 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 Medicare tax may affect you and your family, please contact us.
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.
Dan Romaine is a financial advisor located at 300 Crown Colony Drive, Quincy MA 02169. 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 617-471-6800 or at firstname.lastname@example.org. © 2015 Commonwealth Financial Network®