New Medicare Taxes Take Effect

By Tricia Olson (Spring 2013) Out of the recent budget wrangling in Washington, the most immediate impact for many taxpayers has been in the area of Medicare and Social Security taxes. A temporary reduction of Social Security taxes expired and two new Medicare taxes took effect. This article summarizes the current Medicare and Social Security tax structure. Medicare and Social Security Taxes on Wages Medicare and Social Security taxes (often referred to as “payroll taxes”) are familiar to all of us. Over the last few years, federal legislation made a temporary 2% reduction to the Social Security taxes owed by employees. This reduction expired on December 31, 2012, resulting in slightly smaller paychecks in 2013 as the Social Security taxes returned to their previous rates. For some, paychecks will get even lighter with the January 1, 2013 start of an additional 0.9% Medicare surtax for wage earners whose income exceeds certain thresholds. As of January 2013, effective Social Security and Medicare tax rates on wages are as follows:

For Employees:

[vc_table vc_table_theme=”simple”]TAX,EARNINGS%20TAXED,EARNINGS%20TAXED|Social%20Security%20Tax,Earnings%20up%20to%20%24113%2C700,6.2%25%20%5B1%5D|Medicare%20Tax,All%20earnings,1.45%25%20%5B1%5D|Additional%20Medicare%20Tax,Earnings%20in%20excess%20of%20%24200%2C0002,0.90%25[/vc_table]

For Self-Employed Individuals:

[vc_table vc_table_theme=”simple”]TAX,EARNINGS%20TAXED,EARNINGS%20TAXED|Social%20Security%20Tax,Earnings%20up%20to%20%24113%2C700,12.4%25|Medicare%20Tax,All%20earnings,2.9%25|Additional%20Medicare%20Tax,Earnings%20in%20excess%20of%20%24250%2C000%20if%20married%20filing%20jointly%3B%20earnings%20in%20excess%20of%20%24125%2C000%20if%20married%20filing%20separately%3B%20and%20earnings%20in%20excess%20of%20%24200%2C000%20for%20all%20others,0.90%25%20%5B3%5D[/vc_table]

[3] In addition to the increased Medicare payroll tax, 2013 marks the start of a non-payroll Medicare tax. Known as the Net Investment Income Tax (“NIIT”), this new tax has a rate of 3.8% and applies to Net Investment Income (“NII”) for taxpayers over certain thresholds as follows:

[vc_table vc_table_theme=”simple”]FILING%20STATUS,THRESHOLD%20IN%202013|Married%20Filing%20Jointly,Modified%20Adjusted%20Gross%20Income%20of%20%24250%2C000%20or%20more|Married%20Filing%20Separately,Modified%20Adjusted%20Gross%20Income%20of%20%24125%2C000%20or%20more|Single%20or%20Head%20of%20Household,Modified%20Adjusted%20Gross%20Income%20of%20%24200%2C000%20or%20more|Trust%20and%20Estates,Adjusted%20Gross%20Income%20of%20%0A%2411%2C950%20or%20more[/vc_table]

Taxpayers must report and pay the NIIT on their Form 1040. The NIIT applies to the lesser of (a) the taxpayer’s NII for the taxable year or (b) the excess of the taxpayer’s modified adjusted gross income over the threshold amount.[4] For example, a taxpayer who is a single filer with $180,000 of wages and $90,000 of NII from a passive partnership interest would have modified adjusted gross income of $270,000. The NIIT applies to the lesser of $70,000 (the amount by which the taxpayer’s modified adjusted gross income exceeds the $200,000 threshold) or $90,000 (the taxpayer’s NII). The taxpayer’s NIIT is $2,660 ($70,000 x 3.8%).

NII is a very broad category of income. In a nutshell, unless income is earned as wages or from an active trade or business, it may be NII. The chart below provides a general summary of items that may or may not be NII:


[vc_table vc_table_theme=”simple”],YES,NO|Interest%20Income,X,|Dividend%20Income,X,|Non-Qualified%20Annuity%20Income,X,|Royalty%20Income,X,|Rental%20Income,X,|Passive%20Income,X,|Trading%20In%20Financial%20Instruments%20And%20Commodities,X,|Income%20Derived%20From%20Working%20Capital,X,|Gain%20From%20Disposition%20Of%20Property%20Not%20Held%20In%20Active%20Trade%20Or%20Business%20(Including%20Gain%20On%20Sale%20Of%20Principal%20Residences%20To%20The%20Extent%20It%20Exceeds%20%24250%2C000%20for%20Single%20Filers%20or%20%24500%2C000%20for%20Married%20Taxpayers%20Filing%20Jointly),X,|Wages,,X|Self-Employment%20Income,,X|Income%20from%20Active%20Trade%20or%20Business,,X|Tax-Exempt%20Interest,,X|Unemployment%20Compensation,,X|Life%20Insurance%20Proceeds,,X|Social%20Security%20Benefits,,X|Veterans%E2%80%99%20Benefits,,X|Alimony,,X|Distributions%20From%20Qualified%20Retirement%20Plans%20Or%20Individual%20Retirement%20Accounts,,X[/vc_table]

For owners of entities (i.e. partnerships, LLCs, or corporations), the determination of whether income from the entity is NII will hinge on whether the taxpayer materially participates in the trade or business of the entity. Whether a taxpayer materially participates is fact-specific for each entity. In general, however, this requires regular, continuous and substantial participation by the owner in the entity’s business activity.

As a part of planning to minimize the impact of the NIIT, taxpayers may want to consider some of the following steps:

  1. Invest in tax-exempt bonds, non-dividend paying growth stocks, qualified annuities, or whole life insurance policies.
  2. Time retirement plan distributions so that they do not coincide with years of high NII or consider Roth IRAs[5] instead of traditional IRAs.
  3. Incur expenses that offset NII in the same year NII is recognized.
  4. Reexamine grouping of passive and nonpassive activities.
  5. Consider installment sales of investment assets, or tax-free exchanges.
  6. Make gifts of investment assets.
  7. Evaluate choice of entity. (For example, in some instances, it may be preferable for an LLC to elect to be treated as an S Corporation.)

Taxpayers should not take any of the steps listed above without consulting their investment and tax advisors. It is important for taxpayers to consider all sources of NII and their current year taxable income, as well as anticipated changes to future income. Please do not hesitate to contact us with questions regarding the tax treatment of your business holdings or with general questions regarding the new Medicare tax scheme.

[1] Employers also pay a Social Security tax of 6.2% on an employee’s earnings up to $113,700 in 2013 and a Medicare Tax of 1.45% on all of an employee’s earnings. Employers do not match the Additional Medicare Tax.

[2] Employers must withhold the Additional Medicare Tax from wages it pays to an individual in excess of $200,000 in a calendar year, regardless of the individual’s tax filing status. Married taxpayers who file jointly and are both wage earners may need to make estimate tax payments to allow for the additional Medicare Tax if each spouse’s individual wages are less than $200,000 (thus not triggering the extra withholding), but the combined wages of the two spouses exceed $250,000.

[3] The Additional Medicare Tax is not deductible for income tax purposes, unlike the deduction for 50% of other self-employment taxes.

[4] For trusts and estates, the NIIT applies to the lesser of (a) undistributed NII for the taxable year or (b) the excess of the trust or estate’s adjusted gross income over the threshold amount.

[5] Distributions from qualified retirement plans are not considered NII, but they are included in the calculation of modified adjusted gross income. Distributions from Roth IRAs, however, will not increase modified adjusted gross income.