Starting on January 1, 2013, there is an additional Medicare tax of 0.9 percent on earned income over a threshold amount (this threshold depends on your filing status). This tax was created by the Patient Protection and Affordable Care Act as a way to help pay for health care reform and will take effect in 2013 regardless of any resolutions Congress may come to with respect to the so-called fiscal cliff.
This new tax is only on the worker; not on the employer. The IRS recently provided some guidance in the form of proposed regulations and employers should master them so they can field questions from employees and adjust their payroll system if they handle payroll in-house. The new tax also affects self-employed individuals who have net earnings over the same threshold amounts.
The thresholds and the tax
The thresholds depend on filing status and only reflects earned income:
• Joint filers: $250,000
• Single filers: $200,000
• Married persons filing separately: $125,000
Once earnings pass the threshold, the 0.9 percent additional tax then applies to amounts over the threshold. Thus, if a single individual has a salary of $185,000 and receives a year-end bonus of $40,000, the additional tax applies to $25,000 (the amount of earnings over the $200,000 threshold for a single filer). In effect, the employee pays the basic 1.45 percent Medicare tax on earnings up to the threshold amount ($200,000 in this example), plus 2.35 percent Medicare tax on earnings over the threshold amount ($25,000 in this case). The employer pays 1.45 percent on all of the employee’s earnings.
Earned income for purposes of the additional Medicare tax has the same meaning as used for the basic Medicare tax. Thus, taxable fringe benefits on top of big wages could trigger or increase the additional Medicare tax; tax-free fringe benefits have no impact on the tax.
The tax is paid by the individual when he or she files the return. However, employers must withhold the additional Medicare tax once earnings exceed $200,000. (There is no withholding for this tax in anticipation of having excess earnings.) The employee’s filing status or income from another employer or from self-employment is not taken into account by an employer. If it turns out that the employee does not owe the additional tax (e.g., she is a joint filer and she and her spouse have earnings below $250,000), the over-withholding is claimed as a tax credit on the employee’s income tax return.
The employee cannot ask an employer to withhold any additional Medicare tax. However, if the employee wants a tax-withholding cushion, he or she can have additional income tax withheld. This is done by filing a new Form W-4, Employee’s Withholding Allowance Certificate, with the employer. Then, at tax time, the extra income tax withholding is effectively credited toward the additional Medicare tax.
Special concerns for self-employed individuals
Since self-employed individuals do not have wage withholding, they must incorporate the new tax into their quarterly estimated tax payments. Certainly, a payment need not include any anticipated tax based on expected net income; wait until net income reaches the applicable threshold. Of course, many self-employed individuals do not know their net income until well after the year has ended (some do not know theirs until receiving a Schedule K-1 from a business in which they have an ownership interest).
Use the estimated tax safe harbor rules to avoid any underpayment penalties. Essentially, if estimated taxes for 2013 are based on 100 percent of tax liability for 2012 (110 percent if adjusted gross income in 2012 exceeds $150,000, or $75,000 if married filing separately), then you won’t incur any penalty even if your estimated tax payments fell short of your 2013 tax liability.
This additional Medicare tax on earned income dovetails with another additional Medicare tax on net investment income (called the NII tax). Earned income is specifically exempt from the NII tax but is factored in (as part of modified adjusted gross income) when determining the threshold for imposing the NII tax.
Bottom line: 2013 is going to be a new tax day!
Barbara Weltman is an attorney, author (with such titles as J.K. Lasser’s Small Business Taxes and The Complete Idiot's Guide to Starting a Home-Based Business), and trusted professional advocate for small businesses and entrepreneurs. She is also the publisher of Idea of the Day® and monthly e-newsletter Big Ideas for Small Business® at www.barbaraweltman.com, and host of Build Your Business radio. Follow her on Twitter: @BarbaraWeltman.