If you look closely at your paycheck, you probably have noticed that you pay a certain amount in Medicare taxes.
If you’re an employee, your tax rate starts at 1.45%. If you’re self-employed, you’ll owe 2.9% when you file your taxes (you can also include them in your quarterly estimated tax payments).
However, if you’re a high-earner, you may end up owing even more, thanks to two additional Medicare-related taxes.
The Additional Medicare Tax
If you earn more than $200,000 as a single filer or $250,000 as a married couple filing jointly, you’ll probably have to pay the Additional Medicare Tax of 0.9%. This will lift your total Medicare payroll tax rate to 2.35%.
Your employer will only apply the extra tax if your salary is higher than $200,000.
If your joint marital income exceeds $250,000, you’ll generally have to pay this extra amount when you file your taxes (you can also pay them in advance in quarterly estimated tax payments).
If you’re self-employed, your combined regular Medicare and Additional Medicare tax rate rises from 2.9% to 3.8% when you hit these income thresholds.
Note that this tax only applies to earned income. Once you stop working and live off Social Security payments and income from investments and retirement plan distributions, you’ll no longer have to pay regular Medicare payroll taxes.
The Net Investment Income Tax
If your modified adjusted gross income (MAGI), including Social Security payments, is higher than $200,000 (single filer) or $250,000 (married couple filing jointly), you may have to pay an additional 3.8% Net Investment Income Tax (NIIT) on certain types of investment income, including:
- Taxable interest
- Capital gains
- Nonqualified annuity distributions
- Rental income
- Personal residences with appreciation greater than $250,000 ($500,000 if married)
Municipal bond income is exempt. And distributions from IRAs and pension and employer retirement plan accounts are not immediately subject to the NIIT.
However, if either Required Minimum Distributions or elective withdrawals from your Traditional IRAs and pre-tax 401(k) and 403(b) accounts push your MAGI above the $200,000 or $250,000 threshold, you may have to pay the 3.8% NIIT on that excess amount when you file your taxes.
Calculating your potential NIIT liability
Calculating NIIT is a two-step process:
- Calculate your net investment income on its own.
- Calculate your MAGI (with net investment income included).
Now compare these figures. The 3.8 percent NIIT is applied to the lesser of your net investment income or the amount of MAGI that exceeds your annual $200,000 or $250,000 limit.
For example, let’s say you and your spouse earned a combined total of $175,000 from your jobs, and an additional $100,000 in taxable investment income. In this situation, your adjusted MAGI would be $275,000--$25,000 higher than the current MAGI threshold.
Fortunately, you would “only” to have to pay the 3.8% NIIT on the $25,000 excess amount. Why? Because this amount is lower than your investment income.
Note that this is a very simplified example. Calculating MAGI accurately can be a complex process that may be better handled by your accountant or tax professional.
Unfortunately, being retired doesn’t exempt you from NIIT. If your combined unearned income from Social Security payments, investments and pension and retirement plan distributions puts you above the MAGI threshold, you may still owe NIIT.
NIIT is reported on IRS Form 8960.
How can you plan around these additional Medicare taxes?
If you’re a high earner, there may be ways for you to reduce the impact of both the Additional Medicare Tax and the Net Investment Income Tax. Consider:
- Maximizing your pre-tax 401(k) plan contributions. In 2023, you can contribute up to $22,500 on a pre tax basis—or $30,000 if you’re age 50 or older. These contributions could lower your overall MAGI.
- Reducing your exposure to taxable bonds. Replacing some of these bonds with municipal bonds may lower your MAGI, since muni bond income isn’t subject to federal income taxes.*
- Minimizing short-term capital gains. When you sell appreciated securities you’ve held less than a year, the profits are taxed as ordinary income. If you sell them after a year, profits will be taxed at generally lower long-term capital gains tax rates.
Another option: Roth IRA conversions
If you’re worried that future Required Minimum Distributions (RMDs) from your retirement accounts may push you past your NIIT MAGI thresholds when you’ve retired, consider converting some or all assets from these accounts to a Roth IRA.
Keep in mind that you’ll first need to roll over assets from pre-tax 401(k) and 403(b) accounts into a Traditional IRA. When you move assets from there into a Roth IRA, you'll have to pay federal and state taxes on these withdrawals. But once you complete the conversion, you’ll never have to take RMDs or pay taxes on earnings or withdrawals once you turn 59½ and have owned the Roth IRA for at least five years.
Get professional help
If you’re concerned that your current or future yearly income could subject you to these additional Medicare taxes, you might want to set up a meeting with your accountant or tax professional. If you’re considering making adjustments to your investment strategy, you may also want to bring your financial advisor into the conversation.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax professional or lawyer.
Joelle Spear is a financial advisor and Partner located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. She offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. She can be reached at 508.598.1082 or firstname.lastname@example.org
*Municipal bonds are federally tax free but may be subject to state and local taxes, and interest income may be subject to the federal alternative minimum tax (AMT).
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