Another Tax?

What is this new 3.8 percent Medicare tax everyone is talking about?  If your income is defined as ‘high,’ meaning you earn more than $200,000 as a single filer and more than $250,000 as a married couple filing jointly, this new tax will affect you. Fortunately, we have some time to digest the concept and potentially plan accordingly, because the tax does not go into effect until 2013.

The tax results from the new health care reform law. First, let’s review the current Medicare tax:  At present, the Medicare tax is a “payroll” tax of 2.9 percent.  Employees pay 1.45 percent and their respective employers pay the other 1.45 percent.  Self-employed workers pay the entire 2.9 percent.

Under the new law, high income households will pay (at least) an additional 0.9 percent on income over the thresholds listed above. This means that taxpayers will pay 2.35 percent total for their share of wages OR the full 3.8 percent for high income self-employed or retirees.  Employers will continue to pay 1.45 percent on all wages, regardless of employees’ total wages.  The aspect of the bill that seems most surprising is that the entire 3.8 percent tax will be levied upon households with “net investment income” over the thresholds.  Net investment income is defined to include interest, dividends, rents, royalties, annuities and capital gains.  The tax would not apply to distributions from qualified plans or IRAs, or any investment income characterized as ‘tax exempt.’

The actual language of the bill, in which the tax is discussed reads as follows:

  • “(a) IN GENERAL. – Except as provided in subsection (e) –
  • (1) APPLICATION TO INDIVIDUALS. In the case of an individual, there is hereby imposed (in addition to any other tax imposed by this subtitle) for each taxable year a tax equal to 3.8 percent of the lesser of –
  • (A) net investment income for such taxable year, or
  • (B) the excess (if any) of –
  • (i) the modified adjusted gross income for such taxable year, over
  • (ii) the threshold amount.”

Like most government documents, it can be difficult to understand exactly how a bill might affect you. Following are two examples from a recent blog of “The Finance Buff,” which appeared on April 1, 2010.

For a married couple filing jointly with $260,000 in modified adjusted gross income (MAGI, both earned and unearned):

Example 1: Earned income $259,000, unearned $1,000. The extra 3.8 percent Medicare tax applies to only the $1,000 unearned income. Extra tax = $1,000 * 3.8 percent = $38.

Example 2: Earned income $50,000, unearned $210,000. The extra 3.8 percent Medicare tax applies to the excess of MAGI over $250,000, which is $50,000 + $210,000 – $250,000 = $10,000, because it’s less than the $210,000 unearned income. Extra tax = $10,000 * 3.8 percent = $380.

When the bill goes into effect, it will be the first time in history that payroll taxes will target investment income. One caveat: the way the political world is working these days things could change before 2013 when the bill is scheduled to go into effect.

Jamie Mealey, CPA, CFP®

Jamie is the professional consultant for Dan West and Diane Compardo.

Additional articles