We all knew the Affordable Care Act was going to affect more than the type of medical insurance we can have, and if you are in one of the top two tax brackets, you’re among the lucky ones paying for much of the ACA through two new taxes. The new Medicare tax is an additional 0.9% taken from the paychecks of everyone who earns more than the threshold amount, and the tax on Net Investment Income (NII) takes an extra 3.8% on profits from investments. (The latter is in addition to the higher capital gains tax that upper-income taxpayers are already paying.) (1)
What's more, because the threshold amounts for both the additional Medicare tax and the NII tax are not going to increase based upon inflation, like the Alternative Minimum Tax, more taxpayers will find themselves subject to these new taxes as time goes by and incomes rise.
The additional 0.9% Medicare tax applies once your income from a job (“wages”) exceeds a certain amount:
“A lot of people didn’t fully understand the new tax laws,” says Karen Goodfriend, a CPA and Personal Financial Specialist (PFS) who works in Los Altos, Calif. “It’s complicated. There are new taxes and new thresholds."
As more and more Americans are completing their 2013 tax returns, they are waking up to just how big a bite these taxes can have.
The additional 3.8% Net Investment Income tax applies if: a) you have net investment income, and 2) your modified adjusted gross income exceeds the following thresholds. Note that with the exception of “qualifying widow(er) with dependent child,” these are the same dollar amounts as above.
Note: the thresholds for both new taxes are not indexed to increase with inflation.
Reducing the impact of the additional Medicare tax is difficult unless you're your own boss. One advantage of being self-employed is that you can often control the timing of your income. If you’re able to push income into the following year, you might be able to keep your wages from exceeding the threshold for your filing status. If you work for someone else, then the best you can hope is that your company gives you some flexibility to delay receipt of your bonus until Jan. 1.
By law, your employer must automatically withhold the extra Medicare tax when your income exceeds the threshold. The problem is that if you and your spouse both work outside the home and neither of you individually earns more than the threshold, you will still be liable for this tax if your joint income is more than $250,000. If you haven’t had this taken out of your paychecks, you’ll need to write a check for this amount when you file your tax return. Additionally, you might be subject to a penalty for underpaying your taxes for the previous year. To avoid this, the American Institute of CPAs recommends you increase your payroll withholding or make quarterly estimated tax payments.
Max Out Your Retirement Contributions
Since money you contribute to your employer-sponsored retirement plan is deductible, you might be wondering if this is a way to reduce your wages so they are below the level where the additional 0.9% Medicare tax kicks in. Nice try. Medicare and Social Security taxes are calculated before your retirement plan contributions are taken into account.
But that’s no reason to slack off on your 401(k). Contributions to company-sponsored plans as well as traditional IRAs will still reduce your taxable income. And, that will impact whether you are subject to the Net Investment Income tax.
“The sooner you make a contribution to a tax-deferred retirement account, the better. Not only does this reduce your taxable income, it helps build retirement income,” says John Sweeney, executive vice president at Fidelity Investments. If you have a 401(k), 403(b) or 457 plan through work, in addition to the maximum amount you can contribute is $17,500. However, if you are age 50 or older, the maximum is $23,000 thanks to the $5,500 “catch-up contribution.”
The most you can contribute to a traditional or Roth IRA is $5,500, plus another $1,000 if you qualify for a catch-up contribution.
Last Hope (for 2013)
At this point, says Sweeney, ”you can’t do a lot to affect your 2013 return other than make an IRA contribution.” But instead of waiting until this time next year to come up with the money for your 2014 IRA contribution, he suggests you get started now. “Put a couple of hundred bucks a month in [your IRA].” Virtually every mutual fund company has a free, automatic investing plan and will deduct whatever amount you specify from your bank account on a certain date each month.
The benefit of this approach, called “dollar cost averaging,” is two-fold: not only do you reap whatever gains the markets deliver throughout this year, you also start to live on less income. “You figure out how to make small adjustments so you are saving 10-15% of your income,” says Sweeney. He maintains that if you can learn to live on 85% to 90% of what you earn, “you’ll be better off in the long run. By the time you’re retired, your spending level will be adjusted lower and you’ll have a nice nest egg.”
If your employer gives you the choice of contributing to a Health Savings Account, this can also help reduce your taxable income. Think of an HSA as an IRA for medical expenses. It reduces your current tax bill because contributions are deductible and it reduces your future taxes because withdrawals are tax-free, provided they are used for qualified medical expenses. If you are still working and can afford it, Sweeney recommends not using your HSA account to cover smaller medical expenses such as prescriptions and co-pays. The less you withdraw from your HSA today, the more money you’ll potentially have in the future. Medical expenses tend to increase as you age. When you’re retired and no longer getting a paycheck, he says your HSA represents “a pool of money that has grown tax-free.”
Think of the Kids (or Grandkids)
While it won’t have any impact on the amount of income that is currently subject to tax, Goodfriend encourages clients--many of whom come from the wealthy Silicon Valley area--to consider a 529-college savings plan. The money invested inside these accounts grows tax free if it’s used for qualified expenses and as she points out, “you minimize the income that can be subject to investment income tax” in the future.
Give It Away- Smartly
If you are charitably inclined, don’t write a check! Instead, donate appreciated property to the charity instead of selling it yourself. This prevents you from being pushed into a higher tax bracket and potentially over the threshold for the investment income tax. And, since a charity does not pay tax when it sells securities, it receives all of the proceeds--not just the after-tax amount.