Strategies to Minimize Impact of Increasing Medicare Taxes from ObamaCare Law
The United States Supreme Court's decision to let the Affordable Care Act (ACA) stand means that high-income taxpayers will be paying more Medicare taxes beginning in 2013 thanks to two revenue-raising provisions includes in the Act. This article discusses the new surtax imposed on compensation and self-employment income above a certain threshold, while a companion article considers the new 3.8 percent tax imposed on the net investment income of high-income taxpayers.
The Federal Insurance Contributions Act currently imposes a 2.9 percent Hospital Insurance (HI) tax that is used to fund Medicare. Currently, employees and employers each pay 1.45 percent, with no cap on the amount subject to the tax. Self-employed individuals are liable for the full 2.9 percent, also with no cap on the amount of income taxed. (Self-employed individuals are entitled to an income tax deduction to recoup the employer's portion of this tax.)
Beginning in 2013, high-income taxpayers must pay an additional 0.9 percent Medicare tax on wages or self-employment income in excess of a specified threshold.
This threshold is not indexed for inflation. As a result, an increasing number of people will find themselves owing the surtax, in the same way that the non-indexed Alternative Minimum Tax now hits middle-income taxpayers, rather than only the wealthiest individuals it was intended to tax.
This additional HI tax applies to compensation or self-employment income in excess of
- $200,000 for unmarried individuals;
- $250,000 combined income for married couples who file jointly; and
- $125,000 for a married individual who files a separate return.
Joint filers taxed on combined income. Unlike the general 1.45 percent Medicare tax on wages, the additional 0.9 percent tax is on the combined wages of the employee and the employee's spouse if the couple files a joint return. This creates a "marriage penalty" because high-earning individuals who are married will pay a much higher amount in additional tax than they would if they were unmarried.
Bryan and Liz are married and file a joint tax return. Each of them earns $180,000 per year. For 2013, they will owe an additional $990 in taxes due to the Medicare surcharge. (This is 0.9 percent of $110,000, which is the amount by which their combined income ($360,000) exceeds the $250,000 threshold.)
In contrast, Katherine and Joseph live together, but are not married. They each earn $180,000. They will not owe any additional tax for 2013 because their incomes are not aggregated and neither of their incomes is greater than the $200,000 threshold for unmarried individuals.
Entire burden is on employee. Unlike the current Medicare tax, this additional 0.9 percent is not split between the employee and the employer. The entire amount is borne by the employee. (The employer is required to withhold the amount from the employee's paycheck only when the compensation paid to that employee exceeds $200,000.)
Be mindful if you will incur the additional tax, but your primary employer will not need to withhold it. As the example given above illustrates, this is particularly likely if you are married. It can also occur if you work more than one job, or are self-employed.
In these cases, it is wise to adjust your estimated tax payments to ensure that you are not under-withheld come tax time.
Incorporating May Reduce Impact of Medicare Surcharge
The pending Medicare tax increase should provide a strong incentive to investigate options to reduce the amount of your income that will be subject to the surtax. If you are doing business as a sole proprietorship, a partnership or an LLC, this may be an excellent time to consider incorporating your business.
Incorporating, and then making an S corporation election, will permit you to take a reasonable salary from your corporation and distribute the remainder of the income as dividends. The amounts distributed as dividends are not subject to payroll taxes--including the increased Medicare tax.
Most small business owners actively participate in their businesses. This is critical because it reduces the probability that the distribution will be subject to the new 3.8 percent tax on net investment income.
When implementing this strategy, you must be careful not to overreach and incur the wrath of the IRS. The IRS is cracking down on abuses in this area, so make sure the amount of your salary must be "reasonable" by IRS standards. The IRS considers the following factors when considering if compensation is "reasonable compensation:"
- the nature and size of the business claiming the deduction
- the nature and scope of the work you do for the business
- any special qualifications you may have
- the availability of others to perform the same duties
- general economic conditions
- compensation compared to business income and profits
- compensation relative to dividends
- compensation relative to other employees
- compensation relative to stock ownership if the business is a corporation with more than one shareholder
- your compensation history for past services
Other Strategies Can Reduce Taxable Income
While you can reduce your exposure to the increased Medicare tax by incorporation and changing the nature of the income that your receive from self-employment income to wages, there are other strategies you can consider. These options include:
- Increasing pre-tax contributions to retirement plans
- Shifting income into 2012 through year-end bonuses
- Hiring your children to work in your business
- Reinvesting in your business
Contributions to retirement plans. All wages that are currently subject to Medicare Tax are subject to the Medicare surtax when the individual's applicable threshold is exceeded. Therefore, take advantage of any options that you have to contribute pre-tax dollars to retirement accounts.
If your business does not already have one, consider establishing a retirement plan. For example, in 2012, you can contribute up $50,000 to a simplified employee pension plan. Using this strategy may allow you to avoid the Medicaid surcharge. What's more, distributions from retirement plans are specifically excluded from the new 3.8 percent Medicare tax on investment income. By investing in your own retirement, you can thwart the tax collector on two fronts.
A similar strategy can be used with flexible spending accounts (FSA). However, because the amount that can be contributed to an FSA drops to $2,500 in 2013, this will only help if you are only slightly over the threshold.
Before embarking on any of these strategies, it's a good idea to consult your tax professional who can help you evaluate all of the advantages and disadvantages.