Understand and Plan for the New Medicare Tax - Rodgers & Associates

Understand and Plan for the New Medicare Tax

Understand and Plan for the New Medicare Tax

Many taxpayers didn’t give the new Medicare Tax much thought when it was passed in 2010 as part of the healthcare reform bill. The tax wasn’t scheduled to begin until 2013 and most thought it would be struck down or repealed before it ever took effect. The Supreme Court’s decision to uphold the law in its entirety dashed any hopes of that happening. The new tax combined with the expiring tax brackets will mean a signif­icant tax increase for those affected.


There has been a lot of confusion about the Medicare Tax and when it will apply. To put it simply, the tax applies to the smaller amount of a taxpayer’s net investment income or their modified adjusted gross income (MAGI) over the threshold. The threshold for single taxpayers is $200,000 and $250,000 for married taxpayers filing jointly. MAGI is the number on line 22 of the 2012 IRS form 1040. Distri­b­u­tions from qualified retirement accounts are not subject to the tax but the taxable income from non-qualified deferred annuities is considered investment income and subject to the tax. Other taxable investment income is – passive rental income, royalties, other passive activity income. Income excluded from the tax are – wages, municipal bond interest, life insurance proceeds, social security & veterans benefits, sale of a principal residence and income from an active interest in a business.

Investment income earned inside a trust will be especially hit hard because the threshold is only $12,000 before the tax applies. The threshold for trusts will move up with inflation. If the tax were effective in 2012 it would be $11,650. The $12,000 threshold is an estimate for 2013. The threshold for taxpayers will not be indexed for inflation.

Careful planning will be required for taxpayers that may be subject to this tax. It’s important to under­stand how MAGI is impacted in order to properly plan. MAGI is not impacted by itemized deduc­tions such as medical expenses or chari­table contri­bu­tions. For example, John and Mary Smith have MAGI of $275,000 in 2013. Their threshold as a joint filer is $250,000. If their investment income is at least $25,000 of total MAGI, the entire amount would be subject to the new tax. The Smith’s itemized deduc­tions could total $50,000 and it wouldn’t reduce the Medicare Tax.

Going back to the Smith’s tax return, should their investment income only be $10,000 of their total MAGI, they would owe the new tax on just $10,000. If investment income would be $50,000 of their MAGI, they would owe tax on $25,000. The tax applies only to the smaller amount.

One way to reduce MAGI is to increase contri­bu­tions to employer plans that allow the taxpayer to defer income like 401(k) or 403(b) plans. Salary deferrals reduce the amount of income subject to federal tax and therefore reduce MAGI. John and Mary Smith could contribute a maximum of $17,000 each to their employer’s plan ($22,500 if they are over age 50) and signif­i­cantly minimize this tax. Another way could include changing taxable interest to municipal bond interest which isn’t subject to the tax. They could also harvest capital losses to offset gains to reduce the amount of net investment income.

A longer term plan to minimize the tax would include Roth conver­sions. IRA distri­b­u­tions are not subject to the tax but does count towards total MAGI. Converting IRAs to Roth IRAs will reduce the amount of required minimum distri­b­u­tions at age 70 ½ which could push MAGI over the threshold and expose other investment income to the tax. This may seem like a long way off to some but remember the thresholds aren’t indexed to inflation. The current income levels that expose millions of taxpayers to the Alter­native Minimum Tax (AMT) only affected a few taxpayers when the law was passed in 1969. AMT income thresholds were not indexed to inflation either.

Rick’s Insights

  • Take the time to under­stand MAGI and how the new Medicare tax could impact your taxes in 2013.
  • Consider Roth conver­sions before the end of 2012 as part of your long-term tax planning strategy.
  • Review your net investment income and determine if replacing some of your taxable interest with municipal bond interest would help you avoid the new tax.