When you hear "Medicare taxes," you probably don’t think about your investments. But these taxes, instituted in January 2013, affect many upper-income Americans with higher taxes both on wages and investment income. All the more reason to have a tax-smart financial plan in place.
There are two ways the Medicare taxes affect upper-income people. First, a 3.8% Medicare surtax is levied on the lesser of net investment income or the excess of modified adjusted gross income (MAGI) above $200,000 for individuals, $250,000 for couples filing jointly, and $125,000 for spouses filing separately. (For how MAGI is calculated, see graphic below.) Second, wages above $200,000 (individuals), $250,000 (joint filers), and $125,000 (spouses filing separately) will be subject to higher payroll taxes. Let’s review each provision in detail.
Medicare payroll tax on earned income
The Medicare payroll tax is 2.9%. It applies only to earned income, which is wages you are paid by an employer, plus tips. You’re responsible for 1.45% of the tax, and it’s deducted automatically from your paycheck. Your employer pays the other 1.45%.
High-wage earners will owe an additional 0.9% on earned income above the thresholds mentioned above. So, for example, if you are an individual filer whose income is $225,000, you will pay a 1.45% Medicare tax on the first $200,000, then 2.35% (1.45% plus 0.9%) on the next $25,000. Your employer is required to withhold the extra 0.9% once your wages pass the $200,000 threshold for individuals.
Another example: If you’re married and you and your spouse each earn $150,000, your employers will withhold 1.45% for Medicare tax, because neither of you exceeds the $200,000 individual threshold. But if you file a joint tax return, your combined earned income of $300,000 is $50,000 above the married filing jointly threshold. This means you will have underpaid your Medicare tax by $450 (0.9% of $50,000) and will owe the additional amount when you file your taxes. Speak to your tax adviser about potentially being required to make estimated tax payments.
Tax on net investment income
In the past, taxpayers weren’t required to pay Medicare tax on income generated from investments such as capital gains, dividends, and taxable interest. Since 2013, however, you could owe a 3.8% Medicare tax on some of or all your net investment income.
The amount you owe is based on the lesser of your total net investment income or the amount of your MAGI that exceeds $200,000 for individuals, $250,000 for couples filing jointly, or $125,000 for spouses filing separately.
In other words, you owe the 3.8% tax on the amount by which your investment income exceeds the income thresholds, or, if your wages alone already are higher than the income thresholds, you'll owe tax on the lesser of net investment income or MAGI that exceeds the thresholds.
The chart below summarizes how the Medicare taxes work. Picture three buckets: one for net investment income, one for compensation (like W-2 wages), and one for additional taxable income. Add the buckets together and they equal adjusted gross income. Add foreign earned income and it equals modified adjusted gross income. There are two types of additional Medicare tax: The 3.8% Medicare tax is levied on the lesser of net investment income or MAGI above the thresholds. The 0.9% surcharge is on MAGI above the thresholds.
Three hypothetical examples
Adam’s MAGI is $240,000, of which $180,000 is wages and $60,000 is net investment income. His MAGI is $40,000 over the $200,000 threshold for individuals. He’ll owe the 3.8% Medicare tax on his $40,000 over the threshold, because it is less than his $60,000 in net investment income. Remember, the Medicare tax is based on the lesser of MAGI over the threshold or net investment income. Adam's Medicare surtax will be $1,520 (3.8% of $40,000). He won’t owe a 0.9% Medicare surtax on wages—his wages are below the $200,000 earned income threshold for individuals.
Joan's MAGI is $230,000, of which $220,000 is wages and $10,000 is net investment income. Her MAGI is $30,000 over the $200,000 threshold for individuals. She’ll owe the 3.8% Medicare tax on her $10,000 of net investment income, because it is less than the amount she is over the MAGI threshold ($30,000). Joan will also owe 0.9% on the $20,000 she is over the $200,000 earned income threshold for individuals. So Joan’s Medicare tax will be $560, which includes $380 (3.8% of $10,000) and $180 (0.9% of $20,000).
Paul and Ann’s MAGI is $372,000, of which $330,000 is wages and $42,000 is net investment income. Their MAGI is $122,000 over the $250,000 threshold for married couples filing jointly. They'll owe the 3.8% on their $42,000 of net investment income, because it is less than the amount they are over the MAGI threshold ($122,000). They’ll also owe 0.9% on the $80,000 that their wages are over the $250,000 earned income threshold for married couples filing jointly. Their total Medicare tax surcharge will be $2,316, which includes $1,596 (3.8% of $42,000) and $720 (0.9% on $80,000).
What’s investment income and what’s not
For the purpose of evaluating Medicare tax exposure, it’s important to know that “unearned” net investment income includes net rental income, dividends, taxable interest, net capital gains from the sale of investments (including second homes and rental properties), royalties, passive income from investments in which you do not actively participate (such as a partnership), and the taxable portion of nonqualified annuity payments.
Net investment income does not include tax-exempt interest from municipal bonds (or funds); withdrawals from a retirement plan such as a traditional IRA, Roth IRA, or 401(k); and payouts from traditional defined-benefit pension plans or annuities that are part of retirement plans. Also exempt are life-insurance proceeds, veterans' benefits, Social Security benefits, and income from businesses in which you actively participate, such as S corporations or partnerships.
Determining what is or isn't considered net investment income can be tricky, so it is a good idea to check in with a tax adviser about your situation.
Reminder about withdrawals from retirement accounts
If you’ve reached age 70½ and have begun taking minimum required distributions (MRDs) from a traditional IRA, 401(k) plan, or 403(b) plan, be aware that these withdrawals are included in MAGI and count toward the surtax’s income thresholds. When added to net investment income and any wages, they could push you over the thresholds and subject you to the new tax. Qualified withdrawals from a Roth IRA or Roth 401(k), however, are not included in MAGI and net investment income calculations.
What you can do
Be prepared. If you’re married, filing jointly, and your combined wages will exceed the $250,000 income threshold for couples, you’ll want to make sure that your joint Medicare surtax for the year isn’t significantly higher than you anticipated.
Your employer won’t take your spouse’s income into consideration when figuring your Medicare tax withholding, but you can use IRS Form W-4 to have an additional amount deducted from your pay to cover the extra 0.9% tax on the amount by which you and your spouse exceed the combined income threshold.
Reducing MAGI is difficult for those who are still working. One strategy would be to maximize your contributions to pretax retirement plans like traditional 401(k)s or 403(b)s.
Also, as previously mentioned, qualified withdrawals from a Roth IRA or Roth 401(k) plan are not included in your MAGI.1 If you expect to be close to the MAGI threshold when you begin taking minimum required distributions from a traditional IRA or traditional 401(k), you might consider the effect future taxable distributions will have on your exposure to the tax.
The more complex planning challenges come into play with the net investment income portion of the new tax. But with help from a financial adviser and careful execution of a well-designed plan, there may be ways you can potentially reduce net investment income and, thus, the potential impact of this new tax.
One possible strategy would be to shift some of your investments with taxable earnings into municipal bonds and municipal bond funds, whose earnings are excluded from the MAGI and the net investment income calculation. They also provide a double potential benefit of not triggering the surtax on other investment income and are also excluded from the Medicare surtax. Additionally, investments that produce taxable interest or that pay dividends could be held in a tax-deferred account like an IRA or possibly a tax-deferred annuity.
You may also consider owning a form of permanent life insurance, as the cash value of these polices when withdrawn is not considered net investment income.
All in all, a tax-smart investment plan is more important than ever. Talk to your tax adviser to help ensure your tax planning matches your investment and income needs.
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