Medicare

The New Medicare Tax on Investment Income

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Under the 2010 Health Care Act, Medicare taxes will be going up for certain people on January 1, 2013.  There are two separate Medicare tax increases.  One will be a 3.8% Medicare tax on unearned income.  The other is a 0.9% Medicare tax on wages and self-employment income.  This post describes the 3.8% Medicare Contribution Tax on unearned income.

The Medicare Contribution Tax (3.8%) on Unearned Income

This tax is levied on unearned income such as interest, dividends, annuities, royalties, rents, and capital gains.  It also includes flow through income from an LLC or S corporation in which the owners are not active (e.g., investors ).

The tax is 3.8% of the lesser of:

  • Net investment income OR
  • The excess of modified adjusted gross income over the applicable threshold amount

Some definitions:

Net Investment Income is investment income reduced by investment expenses (e.g., research expenses, advisory fees, etc.)

Modified Adjusted Gross Income is adjusted gross income increased by excluded foreign earned income (there is an exemption from U.S. tax for certain income earned overseas-but this is a topic for a separate blog post).

The Applicable Threshold Amount is $250,000 for joint filers or surviving spouses, $200,000 for single filers, and $125,000 for married filing separate filers.

Net Investment Income Does NOT Include:

  • Distributions from regular or Roth IRAs
  • Distributions from 401(k) or other qualified plans
  • Social Security Income
  • Life insurance proceeds
  • Municipal bond interest
  • Veterans’ benefits
  • Gain from the sale of a personal residence if the gain doesn’t exceed the exclusion amounts of $500,000 for a joint return and $250,000 for a single filer
  • Income from businesses where the owners materially participate

Example:  John files a joint return and has $150,000 in wages, $30,000 in interest income, $70,000 in rental income, and a $30,000 gain on the sale of a rental property.  John’s modified adjusted gross income is $280,000.  John’s net investment income is $130,000 (the $30,000 in interest, $70,000 in rental income, and $30,000 gain from the rental property).  John’s Medicare Contribution tax equals 3.8% times the lesser of:

  • Net investment income of $130,000 OR
  • The excess of modified adjusted gross income over the applicable threshold amount.  This amount is $30,000 ($280,000 modified adjusted gross income less $250,000 threshold amount).

John’s Medicare Contribution tax is therefore $1,140 (3.8% times $30,000).

Example 2: Jill has $200,000 in wages.  She is a passive investor in an S corporation, ABC Corp (i.e., outside of her investment in ABC Corp, she has no involvement in the business).  She has $100,000 in flow through income from ABC Corp.  She also sold some of her ABC Corp stock for a $50,000 gain.  Jill’s modified adjusted gross income is $350,000.  Since Jill is not active in ABC Corp, her flow through profit of $100,000 and her gain on sale of stock of ABC Corp of $50,000 are considered investment income.  Jill’s Medicare Contribution tax is calculated as 3.8% times the lesser of:

  • Net investment income of $150,000 OR
  • The excess of modified adjusted gross income over the applicable threshold amount.  This amount is $100,000 ($350,000 modified adjusted gross income less $250,000 threshold amount).

Jill’s Medicare Contribution tax is $3,800.

Example 3: Joan works full time in her S corporation, ABC Corp.  She has $200,000 in wages and $100,000 in flow-through profit from ABC Corp.  She also sold some of her ABC Corp stock for a $50,000 gain.  Based on Joan’s full time employment in ABC Corp, she materially participates in the business.  Since she materially participates, her flow through profit of $100,000 and gain on sale of stock of ABC Corp of $50,000 are NOT included in net investment income.  Therefore, Joan is not subject to the 3.8% Medicare Contribution tax.

Some tips on avoiding the Medicare Contribution Tax:

  • Try to accelerate income into 2012 so that modified adjusted gross income in 2013 will be under the threshold
  • People owning rental property should try to qualify as a real estate professional
    • This requires more than 50% of time spent in real estate activity and 750 hours per year in real estate activity
    • Consider investing in municipal bonds
      • Municipal bond interest is not subject to the 3.8% tax
      • It also does not increase modified adjusted gross income so it may reduce the tax on other investment income
      • Business owners should try to qualify as active owners in their businesses so that flow through income and gain on sale of ownership interests are not subject to the tax.

For more information on how this applies in your situation, please give us a call.

 

Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

 

Payroll Tax Cut Extended

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Quick Background on Payroll Taxes

The Federal Insurance Contributions Act (FICA) imposes two taxes on employers, employees, and self-employed people.  One tax is the Old Age, Survivors and Disability Insurance (OASDI, commonly known as the Social Security tax).  The other tax is for Hospital Insurance (more commonly known as Medicare A).  The Social Security tax has been 6.2% and the Medicare tax has been 1.45%.  An employee pays the 6.2% Social Security Tax on her first $110,100 of wages (this wage base changes periodically), and pays the 1.45% Medicare Tax on all wages without limit.  The employer must match employees’ Social Security and Medicare Tax contributions.  Therefore, the employee pays a combined Social Security and Medicare tax rate of 7.65% of wages and the employer matches this 7.65% contribution for a combined FICA rate of 15.3%.

Self employed people pay both employer and employee portions of the tax on their self employment income.  The self-employment rate has been 15.3%.  There are two adjustments that self employed people make that are related to self employment tax:

  • The first adjustment is to multiply self-employment income by 0.9235. This adjustment basically allows the employer portion of FICA taxes to be deducted from self employment income.  Notice that the 0.9235 number is equal to 1 – 7.65%.  7.65% representing the employer portion of FICA

Example:  Joan has $100,000 of self employment income from her proprietorship.  She multiplies this income by 0.9235 and the product is $92,350, which is equal to her $100,000 self employment income less the employer portion of 7.65%.  The self employment tax rate of 15.3% is then multiplied by $92,350 to arrive at self employment tax of $14,129.

  • The second adjustment is a deduction equal to one-half of the self employment tax on the self employed person’s tax return.

On Joan’s personal tax return, she would be allowed an above the line deduction of $7,064.50 (one half of the $14,129 self employment tax).

What’s New

During 2011, the employee portion of Social Security was reduced to 4.2% from 6.2%.  The Social Security tax for self-employed individuals was 10.4% (6.2% employer portion plus 4.2% employee portion).  In December 2011, when Congress couldn’t agree on how to fund a full-year extension of the payroll tax cut, it passed the Temporary Payroll Tax Cut Continuation Act of 2011 that provided a two month extension of the 4.2% employee Social Security rate.  On February 17, Congress passed the Middle Class Tax Relief and Job Creation Act of 2012.  This new law extended both the 4.2% Social Security employee portion and the 10.4% Social Security portion of self employment tax until December 31, 2012.

The maximum savings for 2012 will be $2,202 (2% of $110,100) per taxpayer.  If both spouses earn at least as much as the wage base, the maximum savings will be $4,404.

An additional change is made for the above the line deduction for self employment tax.  The deduction is normally one half of the self employment tax to reflect the half that represents the employer portion of the tax.  However, the employee portion of the Social Security tax is 4.2% while the employer portion of the Social Security tax is 6.2%.  Thus, the deduction for Social Security tax is now 59.6% [6.2% employer portion divided by combined employer and employee Social Security tax of 10.4%].  The deduction for the Medicare portion of the self employment tax remains at 50% since the 2% reduction applied only to the Social Security Tax.

Example:  It is now 2012 and Joan still has $100,000 in self employment income.  The first adjustment is still to multiply her $100,000 income by 0.9235.  The product of $92,350 is multiplied by the Social Security portion of self employment tax of 10.4% to arrive at $9,604.40.  The $92,350 is also multiplied by the Medicare portion of self employment tax of 2.9% to arrive at $2,678.15 for a total self employment tax of $12,282.55.  Notice that the self employment tax is less than the first example by $1,846.45.  This difference is due to the 2% reduction in the Social Security portion of self employment tax times the self employment income of $92,350.

To calculate Joan’s above the line deduction:

  • multiply the Social Security portion of self employment tax by 59.6% ($9.604.40 times 59.6% equals $5,724.22)
  • multiply the Medicare portion of self employment tax by 50% ($2,678.15 times 50% equals $1,339.08)
  • Joan’s total above the line deduction for self employment tax is $7,063.30.
Thus, Joan has to cut a check for $12,282.55 to cover self employment tax.  The $7,063.30 above the line deduction for self employment tax is multiplied by her individual tax rate to determine its value.  If Joan is in the 30% bracket, the $7,063.30 deduction will reduce her income taxes by $2,118.99.

Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.

 

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