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How the Two Medicare Taxes affect High-Income Earners

January 10, 2014

Many wealthy taxpayers will end up owing vs. receiving refunds.

Many affluent taxpayers and investors may be surprised to find they owe taxes when they file their 2013 return, rather than receiving a refund. As part of the Patient Protection and Affordable Care Act of 2010, the Internal Revenue Service has started to impose two new taxes on high income-earning individuals: the 3.8% Net Investment Income (Nll) Tax and the 0.9% Medicare Payroll Tax.

The NII will apply to those with a modified adjusted gross income that exceeds $200,000 for singles and $250,000 for married couples filing jointly, and will be assessed to the below items:

  • Dividends
  • Taxable interest
  • Rent
  • Royalties
  • Capital gains
  • Taxable income derived from passive activities in a trade or business

Net investment income does not include interest on tax-exempt bonds, gains from the sale of a principal residence that is excluded from income or distributions taken from a qualified retirement plan, IRA, IRC Section 457(b) deferred compensation plan or IRC Section 403(b) retirement plan. It also does not include income from rental activities of a real estate professional. There are certain criteria that must be met to qualify as a real estate professional. Contact a KLR tax professional to review the rules and see if you qualify. NII is also reduced by certain investment expenses, including state income taxes associated with net investment income.

The 0.9% Medicare tax will be assessed, in addition to the traditional 1.45% Medicare tax (for a combined tax rate of 2.35%) on compensation exceeding $200,000 for single filers and $250,000 for joint filers. Beginning in 2013, employers were required to assess the extra tax once an employee reached the $200,000 threshold for wages, regardless of their filing status. The extra tax assessed on wages is treated as a credit on personal tax returns.

For instance, in the case of a joint filer with wages from only one spouse totaling $240,000, the employer would have withheld the extra .9% on the last $40,000 of wages, or $360. Since the wage earner files jointly and total wages did not exceed the $250,000 threshold for this tax, a $360 credit would be allowed to offset other income taxes or be refunded.

With regard to determining “compensation” for the purposes of the tax, employers generally include noncash compensation, reported tips and nonqualified deferred compensation (as soon as the deferred compensation is “reasonably ascertainable”). Additionally, imputed income on group-term life insurance amounts that exceeds $50,000 will count toward the Medicare wage thresholds. Individuals should keep in mind that the tax will only apply to wages they earned, and employers will not account for any wages earned by a spouse.

These two Medicare-related taxes that went into effect in 2013 will result in a number of individuals facing tax liabilities this year.

Reducing your MAGI to avoid the NII tax in the future

With Dec. 31 past us, it’s not too early to start thinking about 2014. High net-worth individuals seeking to avoid the NII can adopt a number of steps to both reduce their MAGI and put themselves in a better financial position for the New Year. Listed below are common tax strategies individuals and investors rely upon to reduce their net investment income:

  • Sell losing investments to reduce net investment income
  • Increase contributions to a qualified retirement account so that investment earnings are in a tax deferred account rather than a taxable account
  • Shift IRA investment fees to taxable accounts to make them deductible against net investment income
  • Gift appreciated assets to charity rather than use cash to make a contribution
  • For account holders over age 70½ Make a qualified charitable distribution (QCD) from a traditional IRA (if account holders are over age 70 ½)
  • Review investment portfolios to consider investing in municipal or other tax-exempt bond funds

It’s also critical for individuals to keep in mind that the 3.8% Medicare tax also applies similarly to some estates and trusts, so working with a tax professional to establish a comprehensive tax plan that takes these scenarios into account is essential.

Find out more information on the 2016 Tax Brackets: A Complete Guide here.

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