The Patient Protection and Affordable Care Act imposes two new Medicare taxes — one on wages and self-employment income and one on net investment income.
“As a result, executives subject to these new Medicare taxes will now incur a 3.8 percent Medicare tax on most of their taxable income,” says Mark Watson, partner, Houston Tax and Strategic Business Services, at Weaver.
Smart Business spoke with Watson about what this new tax means for executives.
How will the Medicare tax impact wages and self-employment income?
Beginning this year, an additional 0.9 percent Medicare tax is imposed on wages and self-employment income in excess of $250,000 for joint filers and $200,000 for single filers. So, the total Medicare tax on wages and self-employment income is now 3.8 percent, up from 2.9 percent.
If a couple files a joint return, the added tax is imposed on their combined wages and self-employment income. Employers must withhold this additional tax on wages paid to an employee in excess of $200,000 in a calendar year. This withholding applies even though the employee may not actually be liable for the additional tax because, for example, the employee’s wages with that of his or her spouse doesn’t exceed $250,000. Any excess withheld Medicare tax will be credited against the total tax liability shown on the employee’s income tax return.
The $250,000 and $200,000 threshold amounts aren’t indexed for inflation. So, over time, more executives will likely be subject to the additional Medicare tax.
How is net investment income affected?
Many executives also will be subject to a new Medicare tax on their unearned income in 2013. This new tax, commonly called the ‘net investment income tax,’ applies to individuals, estates and trusts when income exceeds $250,000 for joint filers, $200,000 for single filers and $11,950 for estates and trusts, and equals 3.8 percent of net investment income.
Net investment income equals investment income less properly allocable deductions. Investment income includes:
• Gross income from interest, dividends, annuities, royalties and rents.
• Gross income from a passive activity.
• Gross income from a trade or business of trading in financial instruments or commodities.
• Net gain from the sale of property.
• Gross income and net gain from the investment of working capital.
However, gain excluded from taxable income, such as gain on the sale of a personal residence and gain deferred through a like-kind exchange, isn’t included in investment income. Similarly, gain from the sale of certain property used in a non-passive trade or business isn’t included.
Properly allocable deductions include:
• Deductions allocable to rent and royalty income.
• Deductions allocable to income from a passive activity and to a trade or business of trading in financial instruments or commodities.
• Penalties imposed on early withdrawal of funds from a certificate of deposit.
• Investment interest expense.
• Investment adviser fees.
• State/local taxes on investment income.
In the case of an estate or trust, deductions also are available for distributions of net investment income to beneficiaries.
How can these taxes be minimized?
Executives subject to the net investment income tax and the maximum federal income tax rate — applying to joint filers with annual income in excess of $450,000 and to single filers with annual income in excess of $400,000 — will face a 43.4 percent federal tax rate on ordinary income and 23.8 percent federal tax rate on long-term capital gains and qualified dividends. Minimize taxable net investment income by:
• Documenting and claiming all allocable deductions.
• Making distributions from an estate or trust to beneficiaries with income below $250,000 or $200,000 who are not subject to the tax on net investment income.
• Investing through tax-sheltered investment vehicles such as 401(k) plans, Individual Retirement Accounts, annuities and life insurance policies.