[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.
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f carruba says
the 3.8% payroll tax is particularily harsh on those retired with higher incomes, who were previously self employed. for example assume you have a retired couple with $400k in earned income like dividends. the full amount over the $250k threshold would be subject to the 3.8% tax. but if that same couple had a $400k annual distribution from a pension plan or a 401K, there is no extra tax from obamacare.
and of course the expiration of the bush tax cuts just adds to this BOOM for the retired higher earners.
if the bush tax cuts are extended for individuals making less than $200k, it might be advantageous for that example higher income couple to get divorced and split their assets and their income and stay under the threshold???
Harry Sit says
Self-employed people are in the best position to shelter income in tax advantaged accounts. If they didn’t do that, they must have had a very incompetent accountant. In addition, don’t you need something like $20 million to get $400k in dividends today? I wouldn’t worry about a $5,700 tax if I have $20 million.
I agree it would be financially advantageous to get divorced. Whether dodging a small amount of tax is worth the emotional tear is the question. Maybe for those whose love is not so fixated on a piece of paper. I always hear this as a hypothetical. I don’t know anybody who actually pulled it off.
f carruba says
harry, actually it takes only about $6 million in assets if you are earning around 6% on preferred stocks. money just aint what it use to be.
also, the biggest increase coming is not from the obama care tax but for the increased taxes resulting from the failure to extend the bush tax cuts. taxes on qualifying dividends goes from 15% to possibly the highest rate of 39.6%, plus the 3.8%. the presidents current proposal is that the bush tax cuts be extended for individuals making less than $200k, and $250k for a joint return. so this type of income could see an increase of as much as 28.4%
who knows the details of how the extension of the bush tax cuts, if any, will take place. but every since obama has been in office, he has defined the high income earners as $200k and $250k. what ever the issue, this seems to allow for a substantial marriage tax penalty.
Harry Sit says
f carruba – I completely agree with you on the issue of marriage penalty. I don’t care if they do it at 200k/400k or 125k/250k. The marriage penalty in this simply doesn’t make sense.
On the issue of qualified dividends, it depends on what you compare against. Dividends had been taxed as ordinary income for a long time before the Bush tax cuts. You could say dividend earners have enjoyed a very long vacation. It’s time to go back to work. We always wish our vacation is longer but we also know we can’t be on vacation forever. Going back to work is just normal.
f carruba says
so harry, you don’t believe there is justification for and a sense of fairness for the 15% rate because of the double taxation issue?
did you know the 15% rate for divdends was initially proposed by john kerry?
there is no normal in the tax code. every single item gives preference to one group of tax payers over another. the home owner gets preference over the renter; as my first comment stated obamacare gives the receiptient of 401k distributions and pension benefits preferences over the individual who accumulated his assets the hard way, on an after tax basis; california tax payers get a deduction for state income taxes while texas tax payers do not; wages in the form of 401k benefits and medical benefits are tax free, while many do not have access to such; etc.
Harry Sit says
I don’t see a problem. Income is income. If taxing dividend as ordinary income is so unjust, I don’t know why it had to wait for a John Kerry to correct it. You ask Texas taxpayers if they’d like to move to California so they can get a deduction on the California state income tax they will pay.
David C says
@TFB
This Texan is not willing to move to California just for the ability to deduct state income taxes… I’ll gladly pay Washington a wee bit more to avoid paying Sacramento anything. 🙂
(of course I certainly see some perks to prefer living in CA over TX… but taxes/finances is not one of them)
Financial Samurai says
Marriage tax is such a shame.
I’m figuring out how to legally shield 80%+ of my income from 2013 forward. Part of it is just not making much 🙂
NHThinker says
If I’m a 30-yr old engineer making $80K/year and buying a $400K house, given normal rates of inflation on income and house prices, should I expect to pay this tax if I plan to sell my house in 25 years and the law does not change.
The law impacts about 2% of home sellers next year: what percentage of home sellers will it impact in 25 years if the law does not change?
Harry says
NHThinker – Let’s see, say you are single and you remain single. If you stay with the same home for 25 years (rare), your $400k home will be worth $837k at a 3%/year price appreciation rate. Your gain will exceed the $250k exclusion limit by about $187k. The solution: don’t stay in your home for that long. Sell it in year 17 when the appreciation is close to the exclusion limit ($250k single, $500k married). Or get married to get double the exclusion limit. For your salary, if we use the same 3% increase a year, it will be $167k in 25 years. You are still under the $200k line. So you will be OK on that one.