UPDATE: Don’t Ignore the Tax Consequences of the Patient Protection and Affordable Care Act

(Last Updated On: January 24, 2017)

We recently posted an article concerning the self employment tax. Passage of President Obama’s healthcare legislation, the Patient Protection and Affordable Care Act, which the President signed into law on March 23, is cause for an update.

Higher Medicare Payroll Tax on Wages

The Medicare payroll tax is the primary source of financing for Medicare’s hospital insurance trust fund, which pays hospital bills for beneficiaries, i.e., those 65 and over or disabled. Under current law, wages are subject to a 2.9% Medicare payroll tax. Workers and employers pay 1.45% each. Self-employed people pay both halves of the tax, but are allowed to deduct half. Unlike the payroll tax for social security, which applies to earnings up to an annual ceiling ($106,800 for 2010), the Medicare tax is leveled on all of the worker’s wages without limit.

Under the provisions of the new law, which take effect in 2013, most taxpayers will continue to pay the 1.45% Medicare hospital insurance tax, but single people earning more than $200,000 and couples earning more than $250,000 will be taxed an additional 0.9% (2.35% in total) on the excess over those base amounts. Employers will collect the extra tax on wages exceeding the threshold just as they would withhold Medicare taxes and remit them to the IRS. However, companies will not be responsible for determining whether a worker’s combined income with a spouse make them subject to the tax. Instead, some employees will have to remit additional Medicare taxes when they file income tax returns (and some will get a tax credit for amounts overpaid). Self-employed persons will pay 3.8% on earnings over the base amount. Note: the $200,000/$250,000 thresholds are not indexed for inflation, so that it is likely that more and more people will become subject to the higher taxes in the coming years.

Medicare Payroll Tax Extended to Investments

Under current law, the Medicare payroll tax applies only to wages. Beginning in 2013, a Medicare tax will be applied to investment income for the first time. A new 3.8% tax will be imposed on net investment income of single taxpayers with adjusted gross income above $200,000 and joint filers over $250,000 (again unindexed). That 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 deductions properly allocable to such income. The new tax will not apply to income in tax-deferred retirement accounts such as 401(k) plans, so retirement plan distributions are protected. Expect lots of tweaking on this between now and when the tax is actually rolled out in 2013.