Medicare Tax Details Released

The IRS today released proposed regulations and FAQs related to the new Medicare tax on net investment income. For those who haven't heard of it, beginning in 2013 married couples with AGI over $250,000 and singles with AGI over $200,000 will pay an additional 3.8% tax on income meeting the criteria.

Also, there's a new 0.9% surcharge on earned income that exceeds these same AGI treshholds. These new taxes were passed as part of the Affordable Care Act, but only take effect in January 2013.

There have been some open questions about how the investment tax in particular would be applied, and with some proposed regulations now available we have a better sense of it. Much of it is clear from the tax code section itself: dividends, interest, capital gains, and royalties are all subject to the tax. So is income from passive activities. Some comments on the tax and regs:

  • Net investment income is defined to exclude itemized deductions attributable to the income, and the regulations say that "any reasonable method" can be used to do this adjustment. The two common examples of such itemized deductions are state income taxes paid on investment income, and investment interest. Less common are items in the category of miscellaneous deductions, such as investment advisory fees. Miscellaneous deductions have a 2%-of-AGI floor, so must be substantial to be deductible for a high-AGI taxpayer (the floor applies as well to this adjustment). It's possible to come up with more than one method that seems reasonable, so I expect this to be an area requiring some analysis and discussion at tax-prep time.
  • Payouts from retirement plans are not considered investment income. The regs specifically list IRAs, Roth IRAs, and 401(k), 403(b), and 457 plan payouts. This income can raise your AGI though, subjecting you to the tax on other income.
  • Annuity income is investment income. This introduces a tax difference between annuities and qualified plans that didn't exist previously.
  • Nonqualified deferred compensation plan payouts are excluded from investment income, even if they're not subject to FICA (Social Security taxes).

In a sense, this is an entirely new tax. Until now, Medicare was funded by a 2.9% tax on earned income, split evenly between employer and employee. That 1.45% is part of the payroll tax you see deducted on your pay stub. If you are self-employed, you pay the entire 2.9%. Unlike Social Security tax, which is assessed only on earned income up to the current year's Social Security Wage Base, Medicare tax is assessed on all earned income. That means many high-income taxpayers are already paying substantial amounts of Medicare tax.

With the new tax, those affected will pay 3.8% towards Medicare, no matter what the source of that income over $200k/250k is. If it's from job income, you'll pay 2.9% through payroll or self-employment taxes, plus the new 0.9% surcharge. If it's from investment income, you'll pay the 3.8% tax on that type of income. And these are both assessed on your individual income tax return, before you factor in exemptions or most deductions. Bottom line, the tax code is now obtaining additional funding for the Medicare program by taxing any income over $200k/250k.

Tax-exempt interest remains untaxed - for now anyway - so we can start calling it quadruple tax free interest instead of just triple-tax-free. (I just Googled that term and got 0 relevant hits...this may be the first site to ever use it to describe the interest earned on municipal bonds after January 1, 2013. A meme is born!).

The AGI threshholds were meant to capture only "high income" taxpayers, and based on the latest IRS data over 97% of tax returns filed show an AGI under $200,000 so a small percentage will pay this tax. The AGI limits do introduce a new "marriage penalty," in that the limit for a married couple is not double the limit for a single filer (the threshhold for single filers is $200,000 each, allowing $400,000 in total income for an unmarried couple before the tax kicks in). And these AGI threshholds aren't indexed for inflation, so some years from now we'll hit the same issue that we currently do with the AMT patch - a tax scheme intended to assess tax on "high income" individuals, whose dollar amounts are frozen in time.

There's a lot more in the regs & FAQs, those are just a few things that caught my eye. Clients, contact me if you want to discuss how these new taxes may affect you.