Two new taxes in 2013
Wednesday, December 12th, 2012
Two new taxes are scheduled to take effect in January 2013. These taxes were instituted by the Affordable Care Act to help pay for health care reform. Congress may change these taxes as they negotiate ahead of the tax rate and sequestration deadlines at the end of 2012 – the so-called “fiscal cliff”. Few politicians are publicly talking about these taxes, so it appears likely that they will take effect as scheduled. If Congress makes no changes, these taxes will hit those with high earned income and investment income.
Additional hospital insurance tax
Employees pay for Medicare hospital insurance through wage withholding, currently 1.45 %. The additional tax of 0.9% is imposed on combined wages above $250,000 for a taxpayer and spouse filing a joint return or surviving spouse. The threshold is $125,000 for a married person filing separately, and $200,000 in any other case.
This additional tax complicates the tax process for both employers and employees. Under proposed IRS regulations, an employer must withhold this surtax once the employee’s wages exceed $200,000, even if the employee’s W-4 Withholding Allowance Certificate is marked “married”. The new layer of withholding will require adjustments to the employer’s payroll processing system.
The tax also adds complexity to individual tax returns. The employee will be required to reconcile the additional tax when filing his or her Form 1040. Here’s an example:
For a married couple filing jointly, the tax is imposed only on income above $250,000. So the employee (or his tax preparer) must calculate the amount of the excess tax withheld on up to $50,000 of income. This will be applied to the tax due with the individual return, and will adjust the underpayment or overpayment amount.
Medicare tax on investment income
For the first time, Congress has imposed a Medicare tax on net investment income, conveniently called the Net Investment Income tax (NIIT). The tax rate is 3.8%, and is imposed based on the adjusted gross income (with certain modifications) reported on the tax return. The thresholds are $250,000 for joint filers and surviving spouses, $125,000 for married individuals filing separately, and $200,000 in any other case. Trusts and estates with undistributed net investment income are also subject to the tax once their adjusted gross income reaches the highest tax bracket ($11,650 in 2012), with certain exceptions.
The IRS defines investment income in its FAQ page on the subject:
In general, investment income includes, but is not limited to: interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities, and businesses that are passive activities to the taxpayer (within the meaning of IRC section 469).
That last item, passive activities, means net rental income to most of us. If you are actively participating in a business that rents property (a real estate professional), then that income is self-employment income not subject to the NIIT. But if you have a rental house while spending most of your time doing other work, your rent income is subject to the NIIT. This Forbes post is a good treatment of the passive activity rules.
Net capital gains are also taken into account. Three common examples:
- Gains from the sale of stocks, bonds, and mutual funds.
- Capital gain distributions from mutual funds.
- Gain from the sale of investment real estate (including gain from the sale of a second home that is not a primary residence).
Basic rule of thumb
Most income is characterized as earned income or investment income.
If your income is above the threshold for your filing type, you will pay Social Security and Medicare (or self-employment tax) plus the additional hospital insurance tax, or NIIT on income above the threshold.
As always in the Tax Code, exceptions abound. Some examples of income not subject to NIIT:
- unemployment compensation,
- alimony,
- tax-exempt interest,
- Alaska Permanent Fund Dividends,
- distributions from certain Qualified Plans; e.g., pension, IRA, Roth IRA.
Run the numbers
Do you make estimated tax payments during the year? If you anticipate that you will be subject to the hospital insurance and net investment income taxes, you will need to adjust your payments to ensure that you’ve paid enough to avoid an estimated tax penalty. If taxes are withheld from your pay, you may need to adjust the withholding to account for these additional taxes. It pays to get expert help determining what income is subject to which tax and how much extra to pay.