[This is a guest post from Bogleheads investment forum participant Bob’s not my name.]
There’s a lot of talk these days about the new Medicare taxes in the Affordable Care Act (ACA), so you may be wondering how much they will affect you. The short answer is:
- If your household income (married filing jointly) is between $100,000 and $200,000 the effect might be a lot more than you think. I will discuss this in Part 2 of this series.
- If your household income is between $200,000 and $300,000 the effect will be negligible.
- If your household income is over $300,000 you’re probably not reading this column. You have people for that. (I put that in for the hate-the-rich crowd. They won’t otherwise find much to like here.)
Most of the press and angst has been over two new taxes on high income families and singles. I think many people are misunderstanding how they will work. In particular, those just over the $250,000 threshold (married filing jointly) are indignant that they are being singled out — every threshold in the tax code understandably creates this reaction — but I think in most cases they will actually pay no ACA tax.
These taxes are new and confusing to me, too, and we haven’t seen them in action yet, so I could be wrong here. Comments are welcome.
Let’s look at a family that has $260,000 of wages and $15,000 of taxable investment income.
0.9% Medicare Tax on Wages
The new 0.9% Medicare tax applies to wages above $250,000 ($200,000 for singles).
A family with $260,000 of wages would likely have about $4,000 of pre-tax health, dental, and disability insurance premiums, which are exempt from payroll taxes. In addition, they would likely contribute $2,500 each to two Flexible Spending Accounts (FSA), especially if they have teenagers who will be getting braces, having wisdom teeth extracted, and buying contacts, and especially if the IRS modifies the use-it-or-lose-it rule, which it is considering doing. FSA contributions are also exempt from payroll taxes. That puts the family’s taxable wages at $251,000, so $1,000 would be subject to the 0.9% ACA tax, yielding a grand total of $9 of additional tax. Headline: National Debt Down $9 — Ticker Tape Parade Planned.
3.8% Medicare Tax on Investment Income
The new 3.8% Medicare tax applies to investment income to the extent it exceeds $250,000 Adjusted Gross Income ($200,000 for singles).
Our example family has $260,000 of wages, reduced to $251,000 by insurance premiums and FSA contributions. Maxing two 401k’s at $17,000 each would put their AGI at $217,000. This gives them $33,000 of headroom under the 3.8% Medicare tax, enough to accommodate all of their $15,000 of investment income, so they would pay no Medicare tax on their investment income.
These are illustrative numbers. Of course individual circumstances vary. But it’s clear from Internet discussions that people in the $250,000 – $300,000 income range are expecting a huge impact when there may be none at all.
Another example: a family with $280,000 of wages and $25,000 of investment income. The parents are both 50. They max out two 401k’s with catch-up contributions. Their taxable wages are about $271,000 after $4,000 pre-tax insurance premiums and 2 $2,500 FSA contributions. So their additional 0.9% payroll tax is ($271,000 – 250,000) * 0.9% = $189. Their AGI is $271,000 – $22,500 * 2 + $25,000 = $251,000, so their ACA investment income tax is ($251,000 – $250,000) * 3.8% = $38. Total ACA tax burden for this family with $305,000 of income: $227 a year or about sixty cents a day.
The Medicare payroll tax can be mitigated through aggressive use of FSA. The Medicare tax on investment income can be mitigated by (1) lowering your AGI with traditional 401k contributions, FSA contributions, and tax loss harvesting; (2) switching some of your taxable investments to municipal bonds, which are exempt (whether this makes sense overall depends on complex tax tradeoffs regarding where you place bonds in your portfolio), and (3) holding onto appreciated assets until your tax situation is more accommodating (viz., in retirement or any other lower income year).
As frequently noted, the ACA tax thresholds are not inflation-adjusted, which makes them more alarming, but I don’t think we need to be throwing ourselves off the balconies just yet.
It appears the Medicare tax will create withholding problems because the employer has no means to know whether to withhold the extra tax. A couple each making $200,000 (after insurance and FSA) would end up underwithheld by 0.9% x $150,000 = $1,350.
What’s most pathetic about these taxes is that they disappoint everyone (except accountants). The left wants to think they will address inequities they perceive in the tax code. They don’t. The right wants to think they are onerous new taxes on the successful. They aren’t. The middle wants to think they will reduce the deficit. They won’t.
So much for the ballyhooed health care taxes. In Part 2 we’ll look at the unballyhooed.