Additional Medicare tax looms on the horizon

If you and your spouse have self-employment earnings or wages in excess of $250,000, you should be aware of the new tax increase starting in 2013.

The Health Care and Education Reconciliation Act of 2010, which was signed into law on March 30, 2010, created two methods of raising revenue by increasing Medicare taxes by 0.9 percent on wages and self-employment income and by 3.8 percent on net investment income (as discussed previously in the Sept./Oct. issue of Federal Tax Watch).

Prior to 2013, wages were subject to a Medicare tax of 2.9 percent – half (1.45 percent) paid by the employee and the other half paid by the employer. In addition to Social Security tax, self-employment earnings were subject to the 2.9 percent Medicare tax, which equaled the combined rate. Starting in 2013, an additional 0.9 percent tax will be assessed on wages and self-employment income in excess of certain limits, depending on filing status.

It’s important to note that the 0.9 percent additional tax is imposed on the employee only, not on the employer. Accordingly, self-employment income is subject to 0.9 percent, not 1.8 percent. Self-employment income is generally income earned by owners of sole proprietorships and partners in a trade or business partnership.

For those who are self-employed, a deduction of one-half of the self-employment tax (Social Security and Medicare portion) is allowed in determining adjusted gross income on page 1 of their tax return. Note that the new 0.9 percent tax on wages/self-employment income is not eligible for the 50 percent deduction in calculating adjusted gross income.

The structure of the new tax also imposes a marriage penalty because it is assessed on the joint wages in excess of $250,000. Thus, if each spouse earns $200,000, the tax will be paid on the excess wages of $150,000 ($400,000 – $250,000). But if they had remained single and each had earned $200,000, no additional tax would have been due.

Taxpayers may be subject to underpayment penalties in addition to the new tax. This factor is of particular importance when the taxpayer has investment income that is subject to the previously mentioned additional 3.8 percent tax. Employers are required to withhold the new tax only on wages they pay in excess of $200,000. Therefore, a married couple’s earnings may be subject to the additional tax, but their respective employers may not withhold the extra amount.

For example, if each spouse earns $200,000, no withholding would be incurred, but their additional liability would be $1,350 ($400,000 – $250,000 = $150,000 * 0.9% = $1,350).

The same result occurs when an individual changes jobs or has multiple employers. According to the withholding requirements, only wages paid by the specific employer are subject to the additional tax regardless of other employment.

As with many other items in the recent tax changes, the tax thresholds are not subject to inflation adjustments, so the tax burden will increase as time and inflation march on.

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