Medicare taxes can be harmful to your financial health

Two new Medicare taxes will inflict pain on the wallets of many higher-earning taxpayers, especially those with significant investment income. Knowing how these taxes are calculated might be your best remedy.

Single wage earners will have to pay an additional 0.9% Medicare tax on any pay exceeding $200,000. This is on top of the 1.45% tax already owed under the previous rules. Joint filers will pay the extra 0.9% on combined wages exceeding $250,000.

Your employer is responsible for withholding the extra tax, but they probably won’t know how much your spouse earns. So if the salaries of you and your spouse individually are under $200,000 but combined are over $250,000, you will owe the tax when you file your return. This means quarterly estimated tax payments may be required.

The second new Medicare tax affects your investment income. You could pay an extra 3.8% tax on your interest, dividends, rental income, and capital gains. This is in addition to any capital gains or dividend income tax you might already owe.

Here is how it works. You first calculate your Modified Adjusted Gross Income (MAGI). The amount of MAGI that exceeds $250,000 for a joint filer ($200,000 for singles) is compared to just your net investment income. Whichever figure is smaller is multiplied by 3.8% to arrive at your tax. So it’s possible that all of your investment income will be subject to the tax.

Now that you know how the new taxes work, here is how you can help avoid their impact. Before accepting any discretionary wages, watch the thresholds to see if you might owe the 0.9% tax. Minimize the 3.8% investment income tax by having as much of your portfolio in a tax-free retirement plan as possible. And keep your withdrawals from a regular 401(k) or IRA at a minimum to lower your MAGI.

This might also be the time for a Roth 401(k) or Roth IRA. Withdrawals from these are never included in MAGI.

In a taxable account, consider investing in municipal bonds which pay interest exempt from the 3.8% tax. Try to unload stocks that have lost value whenever you sell appreciated securities to help offset net capital gains with losses. Having growth stocks that pay very little in dividends might also make sense.

In the past, paying Medicare taxes was simple. Now these too require a little planning. Call our office for help in mitigating the painful effects of the new Medicare taxes.