The Obscure Tax Hike You May Plan to Avoid

As a result of the Affordable Care Act, the Medicare contribution tax has increased for high earners. How could the Medicare tax affect you?

The Medicare contribution tax

The 2.9-percent Medicare tax continues to be applied to wages and net self-employment income. Half of the tax (1.45 percent) is picked up by the employer and the other half (1.45 percent) by the employee. An additional 0.9-percent tax, made effective in 2013, is now levied on wages and self-employment income above certain thresholds.

Wages or net earnings above $200,000 (single), $250,000 (married), or $125,000 (married but filing separately) will now be taxed at an overall rate of 3.8 percent. The 0.9-percent rate increase applies only to the employee’s (or self-employed taxpayer’s) share of the Medicare tax. Unlike the social security tax, which has a “wage base” ceiling, there is no compensation limit. Each dollar is subject to the Medicare tax.

Tax on investment income

The 3.8-percent Medicare tax also applies to most net investment income. It is applied to the lesser of net investment income or the excess of modified adjusted gross income (MAGI) over the applicable threshold. The exceptions are distributions from retirement accounts—including pensions, 401(k)s, and IRAs—and income generated from municipal bonds. Keep in mind, however, that distributions from retirement accounts can push your adjusted gross income over the threshold, thus subjecting you to a 3.8-percent tax on your other investment income.

The following types of investment income are affected:

  • Taxable interest
  • Capital gains
  • Dividends
  • Nonqualified annuity distributions
  • Royalties
  • Rental income
  • Personal residences with appreciation greater than $250,000 ($500,000 if married)

The law also applies to estates and most trusts. The threshold for estates and trusts is the amount at which their highest tax bracket begins.

Calculating the tax

For individuals, the 3.8-percent Medicare tax is applied to the lesser of net investment income or the excess of MAGI over the applicable threshold ($200,000 for single filers, $250,000 for married filers, and $125,000 for married filing separately).

Example: Mark and Sue have earnings from wages of $175,000 and investment earnings of $100,000. The couple’s total wages and investment earnings (MAGI) equal $275,000. According to the rule, the 3.8-percent Medicare tax will be applied to the lesser of net investment income ($100,000) or the excess of MAGI over the applicable threshold ($25,000). In Mark and Sue’s case, then, only $25,000 will be subject to the Medicare tax. The entire $100,000 in investment income will be subject to either capital gains or ordinary income tax, depending on the nature of the income.

How can you plan around the Medicare tax?

If you believe that your income tax rate will be higher in the future than it is today, you may want to consider taking one or more actions to minimize the impact

Convert Traditional IRAs to Roth IRAs

While the amount you convert from a Traditional IRA or Rollover IRA will be considered taxable income in the year when you make the conversion, after that time Roth IRA assets can grow tax-deferred for federal income purposes, and distributions are tax-free after age 701/2 and once the Roth IRA has been opened for five years.

Establish a trust

Giving highly appreciated assets to a revocable or irrevocable trust can help you avoid paying capital gains taxes when they’re sold within the trust. Likewise, income generated by bonds held by the trust won’t count toward your personal income, either. Any investment-related taxes generated by assets in the trust will be paid by the trust, not you. However, if you do receive income payments from the trust during your lifetime it will be considered taxable income. 

Your CPA or tax attorney may be able to suggest other strategies to reduce your current or projected Medicare taxes. If any of these options require significant changes to your investment portfolio you may want to involve a financial advisor in the discussion as well.  

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 preparer, professional tax advisor, or lawyer.



Joelle Spear is a financial advisor 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 at [email protected]


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