Medicare provides the bulk of healthcare coverage for over 60 million Americans. Most enrollees pay a relatively modest premium for Medicare Part B but get Part A with no extra charge. The majority of funding comes from taxes. Funding sources for Medicare include the Medicare tax and two potential additional Medicare taxes.
What is the Medicare Tax?
Like Social Security taxes and unemployment insurance, the government withholds Medicare tax from employees’ paychecks. Self-employed individuals pay it with their self-employment tax.
According to the IRS, employees and the self-employed pay this tax rate:
- Employees and employers split the 2.9% tax rate, so each pays 1.45%.
- The IRS considers self-employed people both employees and employers, so they pay the entire rate.
- Unlike Social security tax, the IRS does not limit Medicare tax by income.
What is the Medicare Surtax?
The IRS claims that the Medicare surtax begins at these income levels:
- Single, head of household, or qualifying widows or widowers with dependent children: $200,000
- Married, filing jointly: $250,000
- Married, filing separately: $125,000
What is the Medicare Surtax on My Paycheck?
The additional Medicare tax rate of 0.9% more than the regular Medicare tax applies to income earned over the threshold. The IRS notes that taxpayers who must pay this tax should report it on their 1040 and include IRS Tax Form 8959. Employees can find their Medicare wages in box 5 of Form W-2.
Certain benefits that may reduce benefits include:
- Health insurance premiums.
- Contributions to flexible spending accounts for dependent care.
- Contributions to HSAs.
In contrast, contributions to group retirement plans can reduce federal income tax obligations. However, they won’t reduce taxes for the additional Medicare tax or Social Security.
Is There a Medicare Surtax on Investments?
Taxpayers with income over the threshold may also pay an additional 3.8% on certain types of investment income. This income might include:
- Nonqualified dividends
- Taxable interest
- Realized capital gains
The IRS will apply the tax to the lesser of net investment income or the amount modified adjusted gross income exceeds the threshold.
Often called the MAGI, the modified adjusted gross income can vary depending on the specific benefits it’s applied to. For the Medicare surtax, it’s the same as the calculation used to calculate IRA eligibility. The formula adds certain federal tax deductions back to adjusted gross income. Examples of these deductions include student loan and foreign housing deductions.
How to Avoid Medicare Surtax
Some strategies that help reduce income subject to federal taxes won’t help avoid the Medicare surtax. The income calculation for Medicare taxes doesn’t include some deductions that help manage federal income taxes. High-income earners may want to discuss some effective tactics with a financial or tax professional.
Tax Loss Harvesting for Investments
Common wisdom tells investors to buy low and sell high. This sensible approach may not always ring true when figuring taxes into investment returns. For instance, an investor may have a poorly performing asset. Selling it could offset capital gains from other investments to allow a tax deduction of up to $3,000 a year. Proceeds from these investments could also free up cash for more productive investments.
Tax Efficient Investments
Some high-income investors consider investments due to their ability to reduce tax burdens.
For example, city or state governments may offer tax-qualified bonds. Investors can usually enjoy income free from state and federal taxes. Because of this benefit, the bonds may provide lower interest rates than nonqualified bonds. Investors can buy bonds individually or invest in tax-qualified bond funds.
Tax-Managed Stock Funds
The management of some funds may not invest in tax-qualified assets but may manage the portfolio to minimize the tax burden while achieving other investment goals. Some examples of these tactics can include the following:
- Avoiding dividend-paying stocks.
- Offsetting realized capital gains with realized capital losses.
- Holding onto stocks long enough to ensure long-term capital gains rather than short-term ones.
Tax-Efficient ETFs and Mutual Funds
The management of many funds can take steps to minimize tax burdens. Investors should always spend time doing their own due diligence, but some possibilities could include:
- Designers of index funds buy equities to mimic various indexes, like the S&P 500 or the Nasdaq Composite. The nature of these investments may make it less likely that fund managers will trade as frequently, so there’s less risk of generating short-term capital gains.
- Managers can time sales for lots of stocks to participate in loss harvesting and avoid short-term capital gains.
- These funds will not generally sell their total inventory of an equity unless the index removes it entirely. Thus, the portfolio should usually enjoy enough flexibility to time sales to achieve financial and tax-reduction goals.
Individual Investments in Equities
Some investors prefer to research, buy, and sell individual stocks or bonds. Even so, these people can use the same strategies that funds do to factor in tax consequences. Some examples include:
- Avoiding short-term capital gains.
- Harvesting losses
- Choosing growth over taxable dividends.
How to Reduce the Additional Medicare Tax for High-Income Earners
People who earn incomes that could exceed the threshold should consider ways to decrease Medicare wages. Mostly, they should look at the kinds of deductions that can help reduce the MAGI, such as premiums for health insurance, contributions to an HSA, and tax-advantaged accounts for dependent care.
Preparing for Medicare Taxes
Some people may have concerns that their typical income withholdings won’t prove sufficient to cover the bill for Medicare taxes on April 15. For instance, some people have two incomes because of multiple income sources or two spouses. In this case, they might exceed the income threshold but not have enough money withheld. Prudent steps could include increasing deductions and paying estimated taxes quarterly.
- Employer’s Tax Guide, IRS.
- Questions and Answers for the Additional Medicare Tax, IRS.
- What are the Major Federal Payroll Taxes and How Much Money Do They Raise?, Tax Policy Center.