(From the April 4, 2011 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)
High Earners Will Pay Additional Medicare Taxes Beginning in 2013
The Patient Protection and Affordable Care Act as amended (PPACA) added new provisions to the Internal Revenue Code that will impose additional Medicare taxes on higher income individuals beginning in 2013. Two changes were made. First, the employee portion of the Medicare tax will increase by 0.9 percent on wages in excess of the threshold amount. The threshold is $250,000 in the case of a joint return, $125,000 in the case of a married individual filing separately, and $200,000 in any other case. Second, a 3.8 percent Medicare tax will be imposed on unearned income to the extent it causes the individual's modified adjusted gross income to exceed the threshold amount.
Additional 0.9 % Medicare Tax on Wages over the Threshold
The Federal Insurance Contributions Act imposes a tax on employers equal to 6.2 percent of each employee's covered wages up to the taxable wage base (i.e., $106,800 in 2011) for old age, survivors and disability insurance (OASDI tax). It also imposes a tax equal to 1.45 percent of each employee's covered wages for hospital insurance (HI or Medicare tax). After 1993, the cap on covered wages was eliminated for Medicare tax purposes, so the Medicare tax applies to the employee's total covered wages. In addition to the employer, each employee is subject to the same OASDI and Medicare tax - for a total OASDI tax equal to 12.4 percent of the employee's covered wages up to the wage base, and a total Medicare tax equal to 2.9 percent of the employee's covered wages uncapped. The employer is responsible for withholding the employee portion of the OASDI and Medicare tax from the employee's wages.
The PPACA amended Code § 3101(b) - the section which imposes the employee portion of the Medicare tax - effective for remuneration received and taxable years beginning after December 31, 2012, to impose an additional tax on wages that exceed the threshold amount. The "Threshold Amount" is $250,000 in the case of a joint return, $125,000 in the case of a married individual filing separately, and $200,000 in any other case.
How does the additional Medicare tax on wages work in terms of withholding? It works slightly differently than the standard Medicare withholding. The employer is obligated to withhold the additional 0.9 percent Medicare tax only on the individual's wages in excess of $200,000 (disregarding any wages received by the spouse). To the extent that any of the additional Medicare tax is not collected by this additional employer withholding, the individual is obligated to pay the tax. As explained by the Joint Committee on Taxation:
See the Technical Explanation of the Revenue Provisions of the "Reconciliation Act of 2010," as amended, in Combination with the "Patient Protection and Affordable Care Act," prepared by the staff of the Joint Committee on Taxation (March 10, 2010).
The 0.9 percent Medicare tax that is owed but not subject to withholding by the employer must be taken into account by the individual in determining estimated tax payments.
3.8 % Medicare Tax on Unearned Income
New Code § 1411 also becomes effective for taxable years beginning after December 31, 2012, to impose a new 3.8 percent Medicare tax on unearned income for individuals whose modified adjusted gross income (MAGI) exceeds the Threshold Amount (i.e., $250,000 in the case of a joint return, $125,000 in the case of a married individual filing separately, and $200,000 in any other case). The tax is 3.8 percent of the lesser of the "net investment income" for the year, or the amount by which the MAGI for the year exceeds the Threshold Amount. Individuals whose MAGI does not exceed the Threshold Amount are not subject to the tax; and individuals whose MAGI exceeds the Threshold Amount are subject to the tax only to the extent they have "net investment income."
"Net investment income" is defined as the following after reduction for allocable deductions:
Under this definition, the capital gain from the sale of a principal residence that exceeds the amount excludable from tax under Code § 121 (i.e., $250,000, or $500,000 if married and filing jointly) would be net investment income. Notably, income that results from a retirement plan distribution is carved out and does not constitute "net investment income." The carve-out applies to distributions from Code § 401(a) qualified plans, § 403(a) qualified annuities, § 403(b) annuities, § 408 individual retirement accounts, § 408A Roth IRAs, and § 457(b) eligible deferred compensation plans.
MAGI is defined as adjusted gross income, increased by any foreign earned income that was excluded from gross income under Code § 911(a)(1) after allowance for deductions.
A recent report by the Congressional Research Service provides examples of how the 3.8 percent Medicare tax would apply in different circumstances, including the following:
See the CRS Report on The 3.8 % Medicare Contribution Tax on Unearned Income, Including Real Estate Transactions (September 15, 2010).
As with the additional 0.9 percent Medicare tax on wages above the Threshold Amount, the 3.8 percent Medicare tax on unearned income would need to be taken into account by the individual in determining estimated tax payments according to the Joint Committee on Taxation. The Committee also points out that the tax is not deductible for purposes of computing income tax under Subtitle A of the Code.
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