Health Care Reform, Part 3: 2013 Tax Changes

The largest tax impact from health care reform for individuals occurs in 2013.  Four significant changes are as follows:

Increased Medicare Tax on Employees and the Self-Employed.  The Medicare tax is currently 2.90% of wages.  The employee and the employer each pay one-half, or 1.45%.  Self-employed individuals pay both halves, or 2.90%, and may deduct one-half of that amount from income taxes for the deemed employer's share.  For earnings after 2012, the Medicare tax rate on the employee one-half rises to 2.35% on wages exceeding $250,000; $200,000; or $125,000 for joint, single, or separate return filers respectively.  The employer's tax rate remains at 1.45%.  Although the employer isn't subject to the tax rate increase, the employer must withhold the additional 0.90% tax once wages exceed $200,000 regardless of the employee's marital status.  Any shortfall or overage in this additional Medicare withholding tax is the responsibility of the employee and is reported on the income tax return.  The Medicare tax rate for the self-employed rises to 3.80% at the $250,000/$200,000/$125,000 income levels, but there is no increase to the income tax deduction because the rate increase is for the deemed employee's share.  This increased tax on wages has the effect of increasing the cost of the so-called "marriage penalty" where two-earner spouses do not receive the same tax treatment as two-earner, non-married couples.

Medicare Surtax on Unearned Income.  Beginning in 2013, individuals, trusts, and estates are subject to a new, additional Medicare tax of 3.80% on the lesser of:  1) net investment income, or 2) the excess of (modified) adjusted gross income over certain thresholds.  The thresholds are $250,000; $200,000; or $125,000 for joint, single, or separate return filers respectively.  The threshold for trusts and estates is the top income tax bracket amount which is currently only $11,200.  Net investment income includes interest, dividends, capital gains, annuities, rents, royalties, and passive activity income less related investment expenses.  Investment income does not include active trade or business income and gains from disposing of interests in active businesses in which the taxpayer materially participates, distributions from IRAs and qualified retirement plans, tax-exempt interest, gain excluded under from the sale of a principal residence, and any self-employment income.  This is a significant tax increase.  Coupled with the sunset of the Bush tax cuts in 2011, the top federal tax rate in 2013 on ordinary investment income would be 43.4% and on long-term capital gains 23.8%.  A future article will review planning ideas to reduce the impact of this new tax.

Reduction in Itemized Medical Deductions.  Currently unreimbursed medical expenses must exceed 7.5% of AGI to net an itemized tax deduction.  Beginning in 2013 the threshold increases to 10.0% for taxpayers under age 65.  For those age 65 and older, the 10.0% threshold starts in 2017.

Reduction in Health FSA Contributions.  Beginning in 2013, the maximum contribution amount permitted to a flexible spending account for medical expenses is $2,500.  There is no upper limit under current law, except for that imposed under the employer's cafeteria plan.