By Thomas J. Connelly, CFA, CFP
Two new laws were enacted in March of this year. On March 23rd, President Obama signed the Patient Protection and Affordable Care Act that was passed by the Senate on December 24, 2009 and by the House of Representatives on March 21, 2010. The President then signed into law the Health Care and Education Reconciliation Act of 2010 on March 30, 2010. I will highlight the two major tax provisions that will impact individual taxpayers – both of which begin on January 1, 2013.
The first is an increase in the Medicare Part A (hospital insurance) tax rate on wages by 0.9% (from 1.45% to 2.35%) on earnings over $200,000 for individuals (also head of household), $250,000 for married filing jointly and $125,000 for married filing separately. An important feature of this surtax is that wage thresholds are not indexed to inflation. Thus, more and more taxpayers will be affected by this tax as time goes on. There continues to be no income limitation on the Medicare tax. The additional tax incurred is for the employee portion only. There is most likely a disconnect between payroll withholding and taxpayer filing status. For example, a husband and wife both earn $250,000 per year. Payroll processing likely will trigger the 0.9% surtax at the $200,000 individual threshold since the payroll processing firm does not know filing status and if the employee also has a spouse. At tax filing time, the surtax will apply to $250,000 of wages ($500,000 less $250,000 limit), but withholding was only done on $100,000. The taxpayers will then be required to pay Medicare surtax of $1,350 via income tax return. I have not read any clarification on this issue and payroll processing firms are not addressing it yet as they have other immediate issues to resolve from this legislation.
The second new tax involves a Medicare contribution tax of 3.8% on investment income that is calculated by the lesser of net investment income OR the excess of modified adjusted gross income (MAGI) over the threshold amount. First let’s clarify the definition of terms:
Net Investment Income – It is the sum of gross investment income over allocable investment expenses. Investment income for the purposes of this tax includes:
- Interest (tax-exempt interest is excluded)
- Dividends
- Capital Gains
- Annuities
- Rents
- Royalties
- Passive activity income
Investment income does not include:
- Active trade and/or business income plus any investment income derived by the active business
- Distributions from IRAs or qualified retirement plans
- Income derived from self-employment tax purposes
- MAGI – It is the sum of adjusted gross income plus the net foreign exclusion amount.
- Threshold Amount – (Not indexed to inflation)
- Married Filing Jointly – $250,000.
- Married Filing Separately – $125,000
- Single and Head of Household – $200,000
According to CCH, a leading tax information and tax software provider, deferred compensation is a gray area with respect to inclusion of income for this tax. I wish to acknowledge Robert Keebler, a US tax expert, for his overview and the use of the following illustrative examples. One should first look at MAGI amount versus threshold amount to determine if 3.8% Medicare tax applies. If MAGI is less than or equal to threshold amount, then there is no Medicare tax. If MAGI is greater than threshold amount, Medicare tax may apply.
Example 1: Mary, single, only has $225,000 of net investment income. MAGI and net investment income are the same amount, so Medicare tax would be $225,000 less threshold amount of $200,000, which equals $25,000 (tax would be $950).
Example 2: Terry and Tina, married filing jointly, have $300,000 of wages and no net investment income. No Medicare tax applies since there is no investment income.
Example 3: Peter and Paula, married filing jointly, have $400,000 of wages and $50,000 net investment income. MAGI ($450,000) is greater than threshold amount ($250,000), so Medicare tax applies. Tax is based on lesser of investment income ($50,000) or the amount of MAGI over the threshold amount ($450,000 – $250,000 = $200,000). Therefore, Medicare tax applies to $50,000 (tax equals $1,900)
Example 4: Scott and Sarah, married filing jointly, have $200,000 of wages and $150,000 net investment income. MAGI ($350,000) is greater than threshold amount ($250,000), so Medicare tax applies. Tax is based on lesser of investment income ($150,000) or the amount of MAGI over the threshold amount ($350,000 – $250,000 = $100,000). Therefore, Medicare tax applies to $100,000 (tax equals $3,800)
My head is now spinning… how about yours?
Irrevocable trusts have a different set of rules. The 3.8% tax is paid on the lesser of undistributed net investment income or the excess of the trust’s (or estate) AGI over the threshold amount. Threshold amount for trusts in 2013 will be around $12,200 (this threshold amount is indexed to inflation). So, prudent planning must be performed to ensure tax impact is managed properly since the AGI threshold for trusts are significantly lower than all net investment income (or all but the threshold amount). This tactic must be weighed in concert with the desire to keep income in the trust and shelter from an asset protection perspective.
Additional provisions (not an exhaustive list) of the health care legislation also include W-2 reporting requirements for employers (report on employer paid health care premiums) starting next year, tax credits for small businesses to provide health care insurance for their employees starting this year, an excise tax on high-cost health plans starting in 2018, and monetary penalties to individuals that do not have minimum essential health care coverage starting in 2014.
Our already complex tax system has become even more complicated with recent legislation. We recommend that our clients consult with your tax professional and estate planning attorney to gain additional insight/advice into their personal situation. Again, Part Two of this article will explore planning opportunities that should be considered and discussed with your professional advisors. These tax changes will have an effect on many of our clients and the purpose of this article is to detail the impact of what will most likely be tax increases in the tens of thousands of dollars for high income taxpayers.
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