2013 Limits on Medical Deductions

Recent postings have reviewed the Affordable Care Act's (ACA) new Medicare taxes on net investment income and earned income.  A couple of other tax increases also occur in 2013.

Reduction in Itemized Medical Deductions.  Currently unreimbursed medical expenses must exceed 7.5% of adjusted gross income (AGI) to net an itemized deduction.  For tax years beginning after 2012, the ACA raises the threshold 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.  Currently, there is no upper limit on the amount of money that can be contributed on a pre-tax basis to a health care, flexible spending account, except as limited by the employer's cafeteria plan.  For plan years beginning after 2012, the maximum amount that can be contributed to a health care FSA is limited to $2,500; indexed for inflation after 2013.  This low limit will increase both income and FICA taxes on those who would like to contribute more than this amount to pay for their medical expenses.  Coupled with the increase of the AGI limit above, this change is a particularly effective means of raising taxes on sick people.

Increased 0.9% Medicare Tax Rate on Employee Compensation and Self-Employment Earnings

The Medicare tax rate on wages is currently 2.90%.  There is no upper ceiling on the amount of wages subject to Medicare tax.  The employee and the employer each pay one-half, or 1.45%.  Self-employed individuals pay both halves, and may deduct one-half of that amount on their income tax returns.  The Medicare tax rate on the employee’s share rises to 2.35% for compensation received in tax years beginning after 2012.  The increase is part of the Affordable Care Act and applies to wages exceeding $250,000 for joint; $125,000 for separate; or $200,000 for other tax return filing statuses.  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 is reconciled on the employee’s income tax return.

The Medicare tax rate for the self-employed rises to 3.80% at the $250,000/$125,000/$200,000 income levels, but there is no increase to the income tax deduction.  If a person has both wages as an employee and earnings from self-employment, the amounts are combined against a single threshold amount for purposes of computing the tax. 

Notice that the higher Medicare tax increases the cost of the so-called "marriage penalty" because the wages and self-employment income of both spouses must be combined.  A marriage penalty results when two-earner spouses do not receive the same tax treatment as two-earner, non-married couples.  In this case, a married couple receives only one $250,000 threshold amount whereas an unmarried couple receives two $200,000 amounts. 

The threshold amounts are not indexed for inflation.  Therefore, more taxpayers will become subject to the tax in the future. 

Example 1.  Joe earns $175,000 of wages and his wife Cathy earns $175,000 of wages.  Neither employer withholds the extra 0.9% Medicare tax because wages are less than $200,000 each.  Combined wages are $350,000.  Therefore, Joe and Cathy must pay the 0.9% increased Medicare tax on $100,000 of wages or $900.  If Joe and Cathy were an unmarried couple, they would not owe any additional Medicare tax. 

Example 2.  Joe earns $175,000 of wages and his wife Cathy earns $175,000 of wages.  They have $50,000 of net investment income and modified adjusted gross income of $400,000.  Neither employer withholds the extra 0.9% Medicare tax because wages are less than $200,000 each.  Combined wages are $350,000.  Therefore, Joe and Cathy must pay the 0.9% increased Medicare tax on $100,000 of wages and the new 3.8% Medicare tax (see prior posts) on all $50,000 of net investment income on their income tax return.  The extra Medicare tax is $900 on wages and $1,900 on investment income for a total tax increase of $2,800.  Estimated tax payments are necessary to avoid a penalty.