With President Obama’s victory at the polls, it is now abundantly clear that Obamacare is here to stay. So far, we’ve experienced only the easy parts of the massive health care law, but starting in 2013, the hard parts will begin to take effect. In particular, two additional Medicare taxes will kick in. These tax increases will affect only high-income taxpayers: married couples with adjusted gross incomes over $250,000, and singles with AGIs over $200,000.
This is a tiny percentage of the population — only about 4 percent of all taxpayers earn more than $200,000. However, the one-third of taxpayers who itemize could be affected by the more restrictive limits on deducting medical expenses.
Increased Medicare taxes for high-income workers
Everyone who works — whether a business owner or an employee — is required to pay Social Security and Medicare taxes. Employees pay one-half of these taxes through payroll deductions; the employer must pony up the other half and send the entire payment to the Internal Revenue Service. Business owners must pay all of these taxes themselves. These taxes consist of a 12.4 percent Social Security tax up to an annual income limit, and a 2.9 percent Medicare tax on all wage or net self-employment income.
Starting in 2013, the 2.9 percent Medicare tax will go up by 0.9 percent. However, this increase will apply only to married taxpayers with wage or self-employment income of $250,000 and single taxpayers with income of $200,000. Only the amount over these thresholds is subject to the additional 0.9 percent tax.
Thus, for example, a self-employed single person with net self-employment income of $300,000 would pay a 2.9 percent Medicare tax on the first $200,000 and a 3.8 percent tax on the remaining $100,000. If a single employee has wage income of $300,000, the employer would withhold a 1.45 percent Medicare tax up to the $200,000 threshold and 2.35 percent after that.
Employees will have to pay the entire increase out of their own pockets. Thus, employers will continue to pay a 1.45 percent Medicare tax on their employees’ wages. Employees will continue to pay 1.45 percent until their wages reach the $200,000 or $250,000 ceiling. Then they will pay the additional 2.35 percent.
If you’re a high-income taxpayer, you may wish to earn as much money as possible in 2012, rather than in 2013, when it will be taxed at higher rates.
New Medicare tax on investment income
Starting in 2013, high-income taxpayers will be subject to a brand-new Medicare tax on their "unearned income." A 3.8 percent Medicare contributions tax will be imposed on the lesser of (1) the taxpayer’s net investment income, or (2) any excess of modified adjusted gross income over $200,000 ($250,000 for married taxpayers filing jointly).
Thus, all single taxpayers with MAGI over $200,000 and married taxpayers with MAGI over $250,000 will be subject to this tax. This is a small proportion of the population, but a significant one for the real estate industry.
The tax applies only to investment income. This includes:
- gross income from interest, dividends, annuities, royalties and rents other than those derived from an active business;
- the net gain earned from the sale or other disposition of investment and other nonbusiness property; and
- any other gain from a passive trade or business.
This includes just about any income not derived from an active business or from employee compensation.
Example: Sue and Sam, a married couple filing jointly, have a MAGI of $300,000 in 2013, which includes $100,000 of net investment income. Their MAGI is $50,000 over the $250,000 threshold, thus they must pay the 3.8 percent tax on $50,000 of their investment income. This results in a $1,900 tax.
This new tax applies to rental income, except for rentals owned by real estate professionals. So, starting in 2013, real estate professionals who earn profits from rentals will have a substantial tax advantage over everyone else. For details, see "How the new Medicare tax applies to rentals."
Reduced personal deduction for medical expenses
All taxpayers are entitled to a personal income tax deduction for medical and dental expenses for themselves and their dependents. Eligible expenses include both health insurance premiums and out-of-pocket expenses not covered by insurance. However, there are two significant limitations on the deduction, which make it virtually useless (unusable) for most taxpayers.
However, to take the personal deduction, you must (1) itemize your deductions on IRS Schedule A, and (2) only deduct the portion of your medical expenses that exceeds an adjusted gross income threshold. For many years, the threshold has been 7.5 percent of AGI. Starting in 2013, the threshold for the itemized medical expense deduction goes up to 10 percent of AGI. However, people 65 or older will be exempt from the increase until 2017.
Example: In 2013, Sue and Sam have an AGI of $100,000 in 2013 and $30,000 in uninsured medical expenses. They may deduct only the portion of their expenses that exceeds 10 percent of their $100,000 AGI: $10,000. Thus, they may deduct only $20,000 of their expenses.
Because of this tax change, it’s advisable to pay as many medical expenses as possible in 2012, rather than waiting until 2013. See "Deducting health expenses will become more difficult in 2013."
Stephen Fishman is a tax expert, attorney and author who has published 18 books, including "Working for Yourself: Law & Taxes for Contractors, Freelancers and Consultants," "Deduct It," "Working as an Independent Contractor," and "Working with Independent Contractors." He welcomes your questions for this weekly column.