Among the many provisions of last year’s massive health care law, known as the Patient Protection and Affordable Health Care Act, are two notable new taxes that take effect in 2013:
- a Medicare and self-employment income tax surcharge of 0.9 percent for incomes exceeding $250,000 ($200,000 for single); and
- a 3.8 percent Medicare tax on investment income for families with income exceeding $250,000 ($200,000 for single).
While the construction industry watches the continuing debate on the constitutionality of the health care law, construction business owners must prepare to face these new tax provisions in the years ahead.
Higher Medicare Payroll Tax
The Medicare payroll tax is the primary source of financing for Medicare’s hospital insurance trust fund, which pays hospital bills for beneficiaries who are age 65 and older or disabled. Under current law, wages are subject to a 2.9 percent Medicare payroll tax. Workers and employers each pay 1.45 percent. Self-employed people pay both halves of the tax but are allowed to deduct half of this amount for income tax purposes. Unlike the payroll tax for Social Security, which applies to earnings up to an annual ceiling ($106,800 in 2011), the Medicare tax applies to 100 percent of a worker’s wages without limit.
Under the provisions, which take effect in 2013, most taxpayers will continue to pay the 1.45 percent Medicare hospital insurance tax, but single people earning more than $200,000 and married couples earning more than $250,000 will be taxed at an additional 0.9 percent (2.35 percent total) on the excess above their respective base amounts.
The tax functions as an additional employee withholding and does not affect the employer matching portion. But, the employer will face the added burden of processing the new withholdings. Businesses do not need to consider the marital status of their employees. Many will establish a policy to start the extra withholding at the $200,000 threshold, regardless of whether the worker is married.
Consider the tax complications for two-earner marriages whose combined income exceeds $250,000, but neither has wages in excess of $200,000. They will be subject to the increased 0.9 percent on the excess, but none of it would have been withheld because their respective wages were less than $200,000.
Self-employed persons will pay 3.8 percent on earnings above the threshold. But, self-employed individuals will not be permitted to consider the extra 0.9 percent when computing the 50 percent portion of the self-employment tax they can deduct on their personal return. This equates the self-employed individual with the business owner who is not subject to the extra 0.9 percent; therefore, the business owner neither matches the surcharge nor gets a deduction for it.
Tax Extended to Investments
Under current law, the Medicare payroll tax only applies to wages. Beginning in 2013, a Medicare tax will be applied to investment income for the first time. A new 3.8 percent tax will be imposed on net investment income of single taxpayers with modified adjusted gross income (AGI) above $200,000 and joint filers above $250,000.
Net investment income includes interest, dividends, royalties, rents, gross income from a trade or business involving passive activities and net gain from disposition of property (other than property held in a trade or business). Net investment income is reduced by properly allowable deductions to such income.
However, the new tax won’t apply to income in tax-deferred retirement accounts such as 401(k) plans. Also, the new tax will apply only to income in excess of the $200,000/$250,000 threshold. For example, if a couple earns $200,000 in wages and $100,000 in capital gains, $50,000 will be subject to the new tax (i.e., the amount above the $250,000 threshold). The result: a $1,900 tax increase.
Importantly, the new 3.8 percent tax is in addition to any regular tax or capital gains tax imposed on net investment income. If, as expected, capital gains rates go back to 20 percent after 2012 (from the current 15 percent), taxpayers with higher income levels will face an “effective” capital gains rate of 23.8 percent (20 percent plus the new 3.8 percent). That works out to a roughly 60 percent increase in capital gains rates from 2012 to 2013 (8.8 percent/15 percent).
For higher income taxpayers, tax-exempt investments may gain favor because those earnings will not increase AGI, which otherwise would subject more investment income to the new tax. Likewise, Roth IRAs would be more favorable than traditional IRAs and other qualified plans because Roth IRA distributions are not taxable and do not increase AGI.
Consider the gain on the sale of a principal residence in excess of the exclusion thresholds of $250,000 (single) and $500,000 (joint). If the gain on the sale of a principal residence exceeds the exclusion thresholds, then the taxable capital gain portion could be subjected to the new 3.8 percent tax depending on AGI levels.
If an individual plans on selling a principal residence in the next few years and anticipates a gain in excess of the exclusion threshold ($250,000/$500,000), and the AGI would be greater than the new investment tax thresholds (above $200,000/$250,000), it may make sense to sell before 2013. Of course, this may not be feasible given the realities of the current real estate market.
Both Taxes Could Apply Taxpayers who have high wages (or self-employment income) and high investment income could face both the Medicare surcharge and the new tax on net investment income.
For example, a single person with a net investment income of $100,000, wages of $300,000 and AGI of $405,000 would face both new taxes totaling $4,700 in 2013.
He would have to pay $3,800 for the investment income tax, or $100,000 investment income times 3.8 percent. In this example, the excess modified AGI exceeds $250,000 by an amount higher than the investment income ($405,000 less $250,000 is $155,000). So, the lower amount (i.e., the investment income of $100,000) is multiplied by 3.8 percent, resulting in $3,800.
Additionally, he faces the 0.9 percent surcharge applied to his wages in excess of the $200,000 threshold. He has wages of $300,000 less the $200,000 threshold, so $100,000 is subjected to the 0.9 percent, resulting in a surcharge tax of $900.
The $900 surcharge would have been withheld by the employer and paid to the Internal Revenue Service. But, the $3,800 would be computed when the annual tax return is prepared. Both amounts would need to be considered in determining how much the taxpayer needs to pay via quarterly estimated tax deposits.