In my last blog post I wrote about the capital gains taxes that may be due for some shareholders of Medtronic stock. If your income exceeds certain threshold amounts, you may be required to pay an additional 3.8% surtax on top of your capital gains. That’s just one of two new taxes that went into effect in January of 2013 as part of the 2010 Patient Protection and Affordable Care Act.
Medicare tax on earned income
The first tax is a 0.9% increase in the Medicare tax on earned income. It affects taxpayers who exceed certain income thresholds. Single taxpayers with earned income over $200,000, and married taxpayers who file a joint return and have over $250,000 in earned income will pay this tax. Short of taking a pay cut, there is not a lot you can do to avoid this tax.
Employers must withhold this tax from your paycheck. Where you can get into a bind is when your household income exceeds the thresholds ($250,000 for most married couples), but no one individual makes enough to exceed the threshold amounts. In this case, your employer may not be withholding the extra 0.9% from your paycheck. For example, maybe you and your husband both make $150,000. Together you make $300,000. The 0.9% Medicare Tax would apply to the amount of income that exceeds $250,000 or $50,000 in this case. Since your employer is not required to withhold this extra tax from your paycheck, you could end up paying in the difference in April.
Surtax on net investment income
The second tax is a 3.8% surtax on net investment income. This is the one that could add to your tax bill if you have capital gains or interest or dividend income.
The 3.8% Medicare surtax on net investment income applies to those taxpayers whose “modified adjusted gross income” or MAGI exceeds $200,000 (single) or $250,000 (married filing jointly). MAGI is basically the number found at the bottom of page 1 on your 1040. If your MAGI exceeds the threshold amounts you will pay tax based on the lesser of your net investment income OR the amount that your MAGI exceeds the threshold.
Let me give you an example:
If you make $400,000 but have no investment income, then you will owe no additional tax because you had no net investment income. Likewise, if you make $100,000 and have $50,000 of investment income, no tax. In this case, it’s because your MAGI is below the threshold. But if you make over $250,000 and have net investment income, then you pay an additional tax of 3.8% on the lesser of your net investment income or by however much your income exceeds $250,000. So, if you made $260,000 and had investment income of $50,000, then your tax would be 3.8% of…..$10,000 – the amount that your MAGI exceeded the $250,000 income threshold. Does that make sense? If you answered yes, I don’t believe you.
What is net investment income?
Net investment income includes taxable interest, capital gains, dividends, rental income, royalties, the taxable portion of income from annuities, and income resulting from business activity in which you are not considered an active participant (maybe you are a shareholder of a private company or family business, for example). This income will be found in taxable bank accounts as well as brokerage and investment accounts, not in your IRA. Remember, this tax only applies to you if you exceed the above income limits AND have taxable investment income on top of that.
My income is below the threshold
You may be thinking “So what? My income is below the threshold amounts and the tax won’t apply to me”. Maybe you are right, this time. But what about when you exercise your stock options, sell your business, cash out an IRA or 529 plan, sell highly appreciated assets like stock or real estate, accept an early retirement payout, or receive a severance package from your employer? The list of scenarios goes on and on. Your situation could change. Even if you don’t normally make in excess of $200,000 a year, you could be subject to this tax in the future.
How to avoid these taxes in the future
Short of lowering your income there is not a lot you can do about the 0.9% Medicare Payroll Tax. The Surtax on Net Investment Income, however, has some flexibility. As with all tax related matters, consult your tax preparer, financial advisor or other qualified professional. If you want to know more about how these new taxes may affect your investment and retirement income planning, just Ask Mike.