In June, the Supreme Court upheld the Patient Protection and Affordable Care Act (PPACA) originally signed into law in March 2010. The Court held that the requirement that most Americans obtain insurance or pay a penalty was authorized by Congress’s power to levy taxes. David Cordell and Thomas Langdon addressed the insurance mandate provisions of the Affordable Care Act in their September column in the Journal. The purpose of this article is to identify strategies for avoiding the Medicare taxes imposed by the Act and claiming the credit currently being overlooked by many businesses.
The New Medicare Taxes
In an effort to fund the new health care changes and shore up Medicare, which is expected to run out of money in the next decade, the PPACA created two new taxes directed at high-income earners. Taxpayers above the income thresholds could be subject to both taxes. Both taxes are scheduled to begin in 2013.
Higher Medicare Tax on Wages and Self-Employment Income. Under current law, wages are subject to a 2.9 percent Medicare tax with workers and employers paying 1.45 percent each. 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 ($110,100 for 2012), the Medicare tax is levied on all of a worker’s wages without limit.
Under the provisions of the new law, most taxpayers will continue to pay the 1.45 percent Medicare 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 in total) on the excess over those base amounts. Self-employed persons will pay 3.8 percent on earnings over those thresholds. The $200,000/$250,000 thresholds are not indexed for inflation, which means that inflation may cause more people to be subject to this higher tax in the future.
Employers will collect the extra 0.9 percent on wages exceeding $200,000 just as they would withhold Medicare taxes and remit them to the IRS. However, companies won’t be responsible for determining whether a worker’s income from other sources or combined income with his or her spouse makes them subject to the tax. In other words, some employees will have to pay additional Medicare taxes when they file income tax returns, and some will get a tax credit for amounts overpaid.
Increased employer contributions to retirement plans, such as profit sharing and defined benefit plans, and fringe benefit plans, such as medical insurance and disability, in lieu of compensation, avoid the increased tax on wages. However, deferring compensation using 401(k) plans and SIMPLEs and most nonqualified deferred compensation plans do not avoid the tax. Efforts by business owners to replace wages with other forms of income, such as rental income, dividends, or interest on debt, will avoid the payroll tax, but will likely be subject to the Medicare tax on investment income.
3.8 Percent Tax on Investment Income. Starting in 2013, an unearned income Medicare contribution tax is imposed on individuals, estates, and trusts. For an individual, the tax is 3.8 percent of the lesser of (1) net investment income or (2) the excess of modified adjusted gross income (MAGI) over the threshold amount ($250,000 for a joint return or surviving spouse, $125,000 for a married individual filing a separate return, and $200,000 for all others). For a trust, the tax is 3.8 percent of the lesser of (1) undistributed net investment income or (2) the amount of AGI in excess of the threshold for the top trust federal income tax bracket ($11,650 for 2012). The tax applies to income from interest, dividends, annuities, royalties, rents, capital gains, and passive business income, but neither investment income nor MAGI include items such as interest on tax-exempt bonds, veterans’ benefits, and excluded gains from the sale of a principal residence.
As an example, in 2013, Lindsey, a single taxpayer, has net investment income of $40,000 and MAGI of $230,000. Lindsey owes a Medicare contribution tax only on the $30,000 amount by which her MAGI exceeds her threshold amount of $200,000. Thus, her Medicare contribution tax would be $1,140 ($30,000 × 3.8%). If her MAGI had been $300,000, she would have owed $1,520 ($40,000 × 3.8%) on the entire $40,000 of investment income.
Strategies for Avoiding the 3.8 Percent Medicare Tax on Investments
Remember that investment income is defined broadly to include interest, dividend, rental, capital gain, annuity, royalty, and passive activity income, but does not include these income sources if the investment income is received by an active business. Shift investments to corporations and other entities.
Investment income does not include investment income earned in retirement accounts and other nontaxable accounts. Use retirement accounts such as 401(k) plans and traditional and Roth IRAs to hold investments, and clients can save for children’s educations using Section 529 plans and Coverdell Education Savings plans.
Invest in investments that produce nontaxable income, such as municipal bonds and Roth IRAs. Consider converting traditional IRAs to Roth IRAs in 2012 to help minimize MAGI in years when the 3.8 percent Medicare surtax applies.
Annuitize a client’s income stream, creating income that is partially taxable and partially a return of basis, using annuities, life insurance, and charitable remainder annuity trusts.
The Medicare surtax does not apply unless the client’s adjusted gross income is over $200,000 if single ($250,000 if married filing jointly). Use conventional tax-reduction strategies to keep your MAGI below the threshold level.
Investment gains recognized before 2013 will not be subject to the 3.8 percent Medicare surtax. Consider selling stocks or other investment assets before the end of the year if those assets will be sold in the near future.
Investment assets that have decreased in value, such as rental property, can help reduce MAGI in future years. Consider holding on to those assets until after the end of 2012 so the losses upon sale can help shelter clients from the 3.8 percent Medicare surtax.
Gift investment assets to a client’s low-income family members. The future income will not be subject to the 3.8 percent Medicare surtax unless the family member has MAGI in excess of $200,000/$250,000 joint, and the income and future appreciation is out of your client’s estate.
Small-Employer Health Insurance Credit
A small business that offers health insurance to its employees as part of their compensation and contributes at least half the total premium cost is allowed a credit of 35 percent (50 percent for tax years beginning after 2013) of the employer’s contributions toward the employees’ health insurance premiums. The business must have no more than 25 full-time-equivalent employees (FTEs), and the employees must have annual full-time-equivalent wages that average no more than $50,000. The credit phases out as firm size and average wages increase.
The small-employer health insurance credit began in 2010. In a recent U.S. Government Accountability Office (GAO) study, it was reported that fewer small employers claimed the credit for 2010 than were thought to be eligible based on rough estimates made by government agencies. About 170,300 small employers made claims for the credit, while the estimated number of eligible employers ranged from 1.4 million to 4 million. The average credit claimed was about $2,700. The dollar value of all claims made for 2010 was $468 million compared to the $2 billion estimate that was projected when the legislation was enacted.
Many small employers may have missed taking advantage of the credit for 2010 and 2011 due to lack of awareness, lack of time to gather the necessary information, or fear of the complexity of the calculations. However, many small employers may still be eligible to claim the credit. If a business determines that the credit would have been beneficial in a prior year, the business should consider filing an amended tax return within three years of the due date of the return. You or your client can access a brochure and online calculator to see if the credit might apply in your situation at www.assurantemployeebenefits.com/smallbusinesstaxcredit.