Like all taxes, Medicare taxes can be clear as mud. Here, we spell out what every high income earner needs to know about which Medicare-related taxes you may be required to pay.
First, here are the basics of the three types of so-called Medicare tax that might affect you:
Medicare Contribution Tax
There’s a 2.9% Medicare tax applied to wages and net self-employment income. If you are an employee with wage earnings, then you pay 1.45% of that employment tax. Employers pay the other half of the full tax.
Net Investment Income Tax
There’s a 3.8% net investment income tax (from sources such as capital gains, dividends, taxable interest, rental income, passive income and others) that generally applies to high earners with significant investment income. The official name of this tax is the “Unearned Income Medicare Contribution Tax” (which is why it is often put in the Medicare tax bucket), but taxes paid actually go to the country’s General Fund, not to fund Medicare.
Additional Medicare Tax
In addition to the above, you may also be subject to an additional 0.9% tax — commonly referred to as the Medicare surtax — If your income exceeds a certain threshold:
- Married couples filing jointly who have a modified adjusted gross income (MAGI) of more than $250,000;
- married couples who file separate and each have a MAGI of more than $125,000;
- and single filers with a MAGI in excess of 200,000.
What’s the background on these additional taxes?
Both the 3.8% net investment income tax and the 0.9% surtax were instituted in 2013 as part of the Affordable Care Act. Unlike Social Security tax, there is no wage ceiling or compensation limit when it comes to Medicare tax. Every dollar earned as wage compensation or from taxable income is subject to the Medicare tax, as long as you are earning income. This is true even if you’re enrolled in Medicare.
Social Security and Medicare payroll taxes are collected under the FICA tax, which totals 7.65% (6.2% Social Security tax plus 1.45% Medicare tax).
Will these taxes impact you?
Now that we have the fundamentals out of the way, let’s look at some common situations that could trigger these higher Medicare taxes for high income individuals. For personalized information, be sure to consult your tax professional.
Will you receive distributions from a qualified retirement plan?
Distributions from pension plans and IRAs aren’t subject to the 3.8% tax, but if those distributions push your MAGI over the threshold amounts, that could make other investment income subject to the tax.
If you’re a high income individual and don’t have a Roth IRA, this could be cause for considering converting to one: Distributions from a Roth are not subject to the 3.8% tax and won’t be included in MAGI. However, in the year that you convert from a traditional IRA to a Roth, that is counted in your MAGI.
Are you self-employed?
If you are self-employed and have self-employment income that is more than $250,000 for joint filers, or $200,000 for single filers, then you are subject to a base 2.9% Medicare tax as well as the surtax of 0.9%. This brings your Medicare tax to 3.8%. If your income is under the above thresholds, then you pay 2.9% in Medicare tax.
If you make estimated tax payments, be sure to include these figures when you estimate your tax liability. Underpayment could make you subject to penalties.
Are you planning to sell a home?
When selling your primary residence, you might be able to exclude up to $500,000 of gain if you’re filing jointly, and $250,000 if you’re a single filer. Excluding that gain means it won’t be subject to the 3.8% Medicare tax. Selling a second residence does not qualify for the exclusion.
Are you a small business owner?
You’re probably aware that the Social Security wage base increased for 2021, and that the maximum earnings subject to the tax are now $142,800 (up from $137,700 in 2020). As an employer, your FICA tax rate is 7.65%: 6.2% Social Security tax, plus 1.45% Medicare tax. This is unchanged from 2020.
Do you have more questions about how you might be impacted by the Medicare surtax or net investment income tax, or something else? We help high income earners with all aspects of financial planning and wealth management. Contact us today.