Legg Mason Investment Counsel - Increased Medicare Tax

Many taxpayers have heard about the tax laws that expired or changed in 2011 and 2012 as a result of the Tax Relief Act signed into law in December 2010. However, many taxpayers are not as familiar with the increased Medicare tax scheduled to begin January 1, 2013 which was part of the Patient Protection and Affordable Care Act of 2010.

By Ellen B. Hennessey, Tax Specialist

Increased Medicare Tax

The Medicare portion of payroll tax will increase by .9% from 1.45% to 2.35% for single individuals with wages exceeding $200,000 and married couples with wages exceeding $250,000 (threshold amounts for payroll tax). Employers are required to withhold the tax on any individual (whether single or married) whose wages exceed $200,000. Since employers are required to withhold the additional tax on any individual who earns more than $200,000, issues with under withholding and over withholding will arise. For example, a single individual who earns more than $200,000 by working two jobs will find that he owes the increased payroll tax if the tax has not been withheld by either employer because he does not earn $200,000 at either job. If a married couple has combined wages of less than $250,000, but one spouse earns more than $200,000, the couple will have had too much tax withheld. On the other hand, a married couple with combined wages of more than $250,000, but individual salaries of less than $200,000 will be liable for the tax since it has not been withheld by either employer.

In addition, Medicare tax will be charged on investment income for single individuals with adjusted gross income of more than $200,000 and for married couples with adjusted gross income of more than $250,000 (threshold amounts for tax on investment income). Investment income includes, but is not limited to, capital gains, dividends, interest, annuities and royalties. Tax exempt income such as municipal bond interest is not subject to the tax. The rate of tax is 3.8% and the amount of income subject to the tax is the lesser of investment income or the amount by which adjusted gross income exceeds the threshold amount. For example, an individual with investment income of $30,000 and adjusted gross income of $210,000 will only pay tax on $10,000 (the amount by which adjusted gross income exceeds the threshold amount).

The tax on investment income also applies to estates and trusts. The threshold amount is the amount at which the highest income bracket starts ($11,650 in 2012). The tax rate is the same and is imposed on the lesser of the undistributed net income of the estate or trust or the excess of adjusted gross income of the estate or trust over the threshold amount.

The increased payroll tax and the tax on investment income are separate and unrelated. The payroll tax applies only if gross wages are above the threshold amount and the tax on investment income applies only if adjusted gross income exceeds the threshold amount. As such, it is possible for an individual to be liable for one and not the other. A single individual who earns less than $200,000 in wages will not be liable for the increased payroll tax but might be liable for the tax on investment income if his adjusted gross income exceeds $200,000. On the other hand, a single individual might be liable for the increased payroll tax because his wages exceed the threshold amount but not liable for the tax on investment income because his adjusted gross income is less than the threshold amount. Most taxpayers who exceed the wage threshold amount probably will also be subject to the tax on investment income.

The tax is paid in the same maimer as income tax. Taxpayers who are liable for the increased payroll tax (in those situations where there has been no or too little withholding) and taxpayers who are liable for the tax on investment income should make estimated tax payments. The tax will be taken into consideration for purposes of computing the penalty for underpayment of estimated tax. Any shortfall is paid with the taxpayer’s individual income tax return.

While some form of tax is a certainty, the increased Medicare tax is not. The Patient Protection and Affordable Care Act is currently under review by the Supreme Court of the United States with arguments to begin this week. The Court is expected to issue a ruling in June 2012. Opponents have asked the Court to find the Act unconstitutional based on the individual insurance mandate. However, the Court has the option to rule that some parts of the Act are unconstitutional and some parts of the Act are constitutional. Even if the Supreme Court upholds the Act or the increased Medicare tax provision, it is possible that the Act will be repealed. A change in the dynamics of Congress with the upcoming elections could mean repeal of the law since it was passed only with Democratic support. All Republican Senators and 85% of the Republican House members voted against the Act. The Republican presidential candidates have made repealing the Act a major focus of their campaigns.

Tax Tips are for general informational purposes and are not tailored to the financial or tax needs of specific individuals.  Individuals should consult their tax advisors before acting on any information contained herein.  Circular 230 Notice: In compliance with U.S. Treasury Regulations, please be advised that any tax advice given herein (or in any attachment) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax penalties or (ii) promoting, marketing or recommending to another person any transaction or matter addressed herein.

For more information, contact Bill Smith 410-454-3141 Email Bill Smith

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