The ACA's new Medicare taxes: Who pays what?
The law increases the Medicare payroll tax for high-income taxpayers and adds a new tax on their investment income
Although there is much uncertainty over tax rates due to the expiration of the Bush tax cuts and the upcoming debate in Congress about extending them, taxes for high-income individuals will certainly rise in 2013 as the revenue-raising provisions of the Patient Protection and Affordable Care Act of 2010 come into effect.
The law is expected to raise $210.2 billion through 2019 by increasing the Medicare payroll tax for high-income taxpayers and adding a new tax on their investment income.
Currently, Medicare Part A is funded primarily by a payroll tax on wages from employment and self-employment. Employers and employees each pay 1.45 percent of covered wages, and the self-employed pay 2.9 percent of their net earnings from self-employment.
Under the ACA, the employee portion of the hospital insurance tax (as well as the self-employed individual’s hospital insurance tax) is increased by 0.9 percent on wages in excess of $200,000 for an individual filing as single or head of household, $250,000 for a married couple, or $125,000 for a married individual filing a separate return.
For example, an employee filing a joint return will pay hospital insurance tax of 1.45 percent on wages up to $250,000 and 2.35 percent on wages above that.
This tax increase will affect employers as well. Under current law, each employer is required to withhold employees’ share of the tax and is liable for that tax if it fails to withhold.
Starting in 2013, the employer will be required to withhold the extra 0.9 percent only on amounts that it pays over $200,000, even though the tax may apply to lesser amounts if the employee has other sources of earned income, such as a spouse or second job. This is an administratively simple solution for the employer, but employees may find that they need to increase their withholding or make additional estimated tax payments in order to avoid incurring penalties for underpayment of estimated tax.
The new tax
In addition to increasing payroll taxes for high-income taxpayers, the ACA extends the hospital insurance tax to apply to the net investment income of individuals, estates and trusts.
For an individual, the tax is 3.8 percent of the smaller of net investment income or the excess of modified adjusted gross income (adjusted gross income increased by certain foreign earned income) over $250,000 for a married couple or surviving spouse, $125,000 for a married individual filing a separate return, or $200,000 for anyone else.
In other words, taxpayers are subject to the tax on all of their investment income only if their modified adjusted gross income exceeds the applicable amount by at least the amount of their net investment income.
This new tax also applies to trusts and estates. For trusts and estates, the tax is on the smaller of undistributed net investment income or the excess of adjusted gross income over the dollar amount at which the highest income trust and estate tax bracket begins ($11,650 plus an adjustment for inflation).
Notably, the tax applies to net investment income, but does not apply to income from most businesses conducted by a sole proprietor, partnership or S-corporation, interest on tax-exempt bonds, veteran’s benefits, or the excluded capital gain from sale of a principal residence.
Although the payroll tax increase and the new tax on investment income may sound burdensome for those in the highest tax bracket, many commentators have cautioned that they must be put in historical context.
The trend in the post-war era has been downward from a high point of over 90 percent for ordinary income and 35 percent for long-term capital gains. Over the last 25 years, top rates on ordinary income have hovered between 31 and 39.6 percent and top rates on long-term capital gains have been between 15 and 28 percent.
The top marginal rate for individuals is currently 35 percent for ordinary income and 15 percent for long-term capital gains. The ACA will make the top marginal rate on long-term gains 18.8 percent.
Depending on congressional action (or lack thereof), if the Bush tax cuts are allowed to expire, the top marginal rate on ordinary income will increase from 35 percent to 39.6 percent (which could increase the top rate on dividends to 43.4 percent (39.6 percent plus 3.8 percent), and the top marginal rate on long-term capital gains will increase from 15 percent to 23.8 percent (20 percent plus 3.8 percent).
Whether one considers the new taxes historically low or painfully high, careful tax planning this year may result in tax savings for those who are able to recognize income this year rather than in later periods.
In particular, taxpayers considering selling capital assets, like second homes, homes with built-in gains greater than the exclusion for primary residences, or stocks, may wish to consider timing these sales to make 2012 rates applicable.
Likewise, taxpayers who are considering converting a regular IRA, 401(k) or 403(b) to a Roth IRA would do well to make those rollovers effective in 2012.
Generally, taxpayers who are in the highest income bracket would do well do check in with their tax advisers soon about potential planning opportunities.
Catherine Hines, an attorney in the Tax Department of the McLane Law Firm, can be reached at 781-904-2686 or at email@example.com.