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.