Summer is a great time to contemplate anything but your tax situation. However, this year there are two new taxes that could be significant to you that you should consider now. Both new taxes are related to Medicare funding and higher income taxpayers. Also, both new taxes hinge on how high your modified adjusted gross income (MAGI) is. I will not bore you with the details of how MAGI is calculated, and just say that if the number at the bottom of the first page of your 1040 is $200,000 or more, you probably need to pay attention.
First up is the 3.8% tax, a.k.a. the Medicare Contribution Tax. The tax is designed to collect Medicare tax on net investment income such as dividends, interest, rent and royalties. Net investment income has not historically been subject to Social Security and Medicare withholdings, at least until now.
So do you have to worry about this tax or not?
If your MAGI is less than the threshold ($200,000 single, $250,000 married filing joint) the answer is no. However, if you do have income over the threshold, here’s more about how the tax works:
It is a 3.8% flat tax on net investment income
- Net investment income includes dividends, interest, net rental income, passive income from partnerships, and net capital gain income, less investment expenses.
- Net investment income does not include social security income, pension income, IRA distributions, salaries, wages, tips, and business income subject to self-employment tax.
The 3.8% tax is assessed on the lesser of
- The difference between your total AGI and the threshold for the tax (i.e. $200K single and head of household, $250K married joint) or
- All of your net investment income.
If your MAGI is over the threshold, but all or most of your income is from a paycheck or self-employment income, you may be subject to the Additional Medicare Tax. This tax is an extra 0.9% tax on earned income. If you earn $200,000 or more your employer probably is withholding for this tax already.
Can you avoid or reduce the impact of these new taxes? You can if have a good opportunity to lower your MAGI, and the cost of that opportunity is less than the benefit you will receive in lower taxes. Here are some potential actions you can take:
- Defer income by contributing to a qualified retirement plan, such as a 401K, SEP, profit sharing plan or SIMPLE.
- Reduce business income by increasing purchases of fixed assets or by spending for other business expenses and inventory prior to yearend.
- Take some capital losses. If you have some loser investments in your portfolio that are not worth keeping, go ahead and sell them. The losses will offset any capital gains you recognize this year plus $3,000.
- Fully fund your Health Savings Account (HSA).
A couple other thoughts for you to chew on
- Lowering MAGI will also lower your income taxes and can provide other benefits on your tax return.
- If you are just barely over the threshold for these taxes, your tax increase attributable to the new Medicare taxes probably won’t be very much.
- Increasing itemized deductions, such as charitable contributions, will not help you with this tax.
It’s a good idea to consult with your tax preparer and/or your personal financial consultant to explore the best options for you to minimize your tax liability, so you can take action now and go back to enjoying your summer.