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Some Federal Employees Will Pay an Additional 0.9 Percent Medicare Hospital Insurance Tax
The additional 0.9 percent Medicare HI tax is a result of the passage of the Affordable Care Act of 2010 which was passed into law in March 2010. The tax applies only if an individual's modified adjusted gross income (MAGI) exceeds $200,000 for unmarried individuals, $250,000 for married individuals filing jointly and $125,000 for married individuals filing separately. MAGI during 2013 is calculated by taking one's 2013 adjusted gross income (AGI) and adding any foreign earned income exclusion used during 2013. Note that the $200,000/$250,000 MAGI thresholds are not adjusted annually for inflation.
The current Medicare HI payroll tax is equal to 1.45 percent of an employee's gross wages with a matching contribution of 1.45 percent from the employer. If an employee is subject to the additional Medicare HI tax on the employee's salary, then the employee will pay a total Medicare HI tax of 2.35 percent (1.45 plus 0.9) on the employee's salary. But the employer will match only the employee's portion of the Medicare HI tax of 1.45 percent, even if the employee is paying the HI tax at a rate of 2.35 percent.
The additional HI tax is payable whether or not it is withheld by the employer. The rule is that an employer must withhold the additional 0.9 percent only if an employee's wages exceed $200,000 during the tax year, even if the tax is ultimately not paid. The following example will help illustrate this point.
Example 1. Paul is a federal employee with W-2 earnings during 2013 of $152,000. Paul will have other income during 2013, including interest, dividends and rental income, totaling $40,000 for a total MAGI of $192,000. Since Paul's MAGI will be less than $200,000 during 2013, Paul will not owe the additional 0.9 percent Medicare HI tax on his wages. Paul's payroll office will not withhold the additional 0.9 percent Medicare HI tax because Paul's gross salary during 2013 is less than $200,000.
Example 2. Ron and Carol are married and are both federal employees. Ron will earn $130,000 during 2013 and Carol will earn $125,000 during 2013, for a combined earned income of $255,000. Ron and Carol will have no other income during 2013. Since their MAGI will exceed $250,000 during 2013, they will owe the additional 0.9 percent Medicare HI tax on their salaries. Note that neither Ron nor Carol's payroll offices will withhold the additional 0.9 percent Medicare HI tax from Ron and Carol's salaries since neither salary exceeds $200,000. Ron and Carol will pay the additional Medicare HI tax equal to 0.9 percent times $5,000 ($255,000 less $250,000) when they file their 2013 federal income tax return in the spring of 2014.
Example 3. Alex is a federal employee and is married. Alex's wife will have no earned income during 2013. Alex's earned income during 2013 includes a salary from his federal job of $150,000, self-employment income from Alex's consulting business of $55,000 and additional investment income of $55,000. Alex and his wife's MAGI for 2013 will be $260,000. Alex will owe the additional 0.9 percent Medicare HI tax because his combined earned income exceeds $200,000 ($150,000 plus $55,000, or $205,000). The additional tax will be equal to 0.9 percent of $205,000 less $200,000, and will be paid when Alex and his wife file their 2013 federal income taxes in the spring of 2014.
What Federal Employees Should Do to Avoid the Additional Medicare HI Tax
1. Since the additional Medicare HI tax is triggered only if an employee's MAGI exceeds certain thresholds ($200,000 for single, $250,000 if married filing jointly, or $125,000 if married filing separately), those employees who think they will be close to the MAGI threshold during 2013 should consider contributing to the traditional TSP rather than the Roth TSP during 2013. Contributing to the traditional TSP reduces an employee's gross salary which in turn will reduce the employee's MAGI.
2. Similar to #1, one's investment income -- this includes interest, dividend and capital gain income -- can result in an employee's exceeding the MAGI threshold when combined with earned income. Employees who may be affected by the traditional Medicare HI tax should therefore invest in investments that yield tax-free income, including tax-free municipal bonds. They should also be careful in selling investments that will result in huge capital gains.
3. Under the Pension Protection Act of 2006, effective Jan. 1, 2010, any individual may convert a traditional IRA to a Roth IRA. But in converting a traditional IRA to a Roth IRA the IRA owner must include the taxable portion of the traditional IRA being converted as income for the year. This includes deductible contributions and accrued earnings. The additional income resulting from conversion could trigger the additional Medicare HI tax if the MAGI thresholds are exceeded.
For those employees who are or perhaps in the future will be affected by the additional Medicare HI tax, there will be no effect on their eligibility as to when they can enroll in Medicare Part A (age 65) nor on their Medicare Part A benefits.
Those employees who are affected by the additional Medicare HI tax may also be affected by the 3.8 percent Medicare surtax on net investment income that also took effect on Jan. 1, 2013. The surtax - which is paid in addition to other taxes (ordinary tax on salary/interest/short term capital gains/rental or other income and "preferential" tax on long term capital gains and qualified dividend income) on investment income - applies to the unearned income of single filers and heads of household with MAGI above $200,000, to the unearned income of married individuals filing jointly with MAGI over $250,000, and to the unearned income of married individuals filing separately with MAGI over $125,000. The surtax is levied on the smaller of the individual's net investment income or the excess of MAGI over the applicable MAGI dollar threshold. Net investment income includes interest, dividends, capital gains, nonqualified annuities (fixed and variable), royalties, and passive rental income. Tax-free interest and dividend income is exempted from the Medicare surtax, along with payments from CSRS and FERS annuities, the TSP, traditional and Roth IRAs, and other qualified pension plans.
About the Author
Edward A. Zurndorfer is a Certified Financial Planner, Chartered Financial Consultant, Chartered Life Underwriter, Registered Health Underwriter, Registered Employee Benefits Consultant and Enrolled Agent in Silver Spring, MD -- and the owner of EZ Accounting and Financial Services, an accounting, tax preparation and financial planning firm also located in Silver Spring, MD. Zurndorfer is also is an instructor at federal employee retirement seminars throughout the country and writes numerous columns and books on federal employee benefits.