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IRS Provides Guidance on the New 0.9 Percent Medicare Tax

The IRS recently issued much-anticipated guidance on the new 0.9 percent Medicare tax on wages and self-employment income. The new tax, which will only affect upper-income individuals, takes effect on January 1, 2013.

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Basics on the New Tax

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Before 2013, the Medicare tax on salary and net self-employment (SE) income was a flat 2.9 percent.

• If you are an employee, 1.45 percent was withheld from your paychecks, and the other 1.45 percent was paid by your employer.• If you are self-employed, you paid the whole 2.9 percent Medicare tax yourself as part of the self-employment (SE) tax.

Things have changed. The healthcare legislation (passed in 2010) added an extra 0.9 percent Medicare tax on:

• Salary and/or SE income above $200,000 for unmarried individuals.• Combined salary and/or net SE income above $250,000 for married joint- filing couples.• Salary and/or net SE income above $125,000 for married individuals who file separately.

Impact on Employees:

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» If you are a higher-income employee, your employer must withhold the new 0.9 percent Medicare tax from your paychecks, starting in 2013. That will result in a maximum Medicare tax wage withholding rate of 2.35 percent (1.45 percent plus 0.9 percent) for 2013 and beyond.

The maximum wage withholding rate for Social Security and Medicare taxes combined will be 8.55 percent (6.2 percent for Social Security plus 2.35 percent for Medicare) for 2013 and beyond.

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Impact on Self-Employed Individuals:

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» If you are a higher-income self-employed person, you will pay the new 0.9 percent Medicare tax as part of your SE tax bill, starting in 2013.

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» The maximum rate for the Medicare tax component of the SE tax will be 3.8 percent (2.9 percent plus 0.9 percent) for 2013 and beyond and the maximum SE tax rate will be 16.2 percent (12.4 percent for the Social Security tax component plus 3.8 percent for the Medicare tax component) for 2013 and beyond.

Note: The extra SE tax hit from the new 0.9 percent Medicare tax will not qualify for the longstanding deduction for 50 percent of your SE tax bill.

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Impact on Estimated Tax Payment Obligations:

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» If you owe the new 0.9 percent Medicare tax, you should take it into account in determining the amount of quarterly estimated tax payments that you will need to make to avoid the IRS interest charge penalty on insufficient estimated tax payments.

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Note that you can potentially be affected by this issue even if all your income is from wages earned as an employee, because your employer might not withhold enough from your wages to cover the new tax.

For example, this might happen if both you and your spouse work as employees, but only one of you or neither of you has high enough wage income be subject to withholding for the new 0.9 percent tax (see Example 2 below).

Highlights from the New IRS Guidance

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The recently issued IRS guidance on the new 0.9% Medicare tax comes in the form of so-called proposed reliance regulations--which taxpayers can rely on even though they are only proposed rules--and 47 questions and answers (FAQs) that have been posted on the IRS website. Here are the highlights.

Employer Withholding Guidance

The new 0.9 percent Medicare tax only applies to employees -- not employers. However, employers must begin withholding the new tax once your 2013 wage income exceeds $200,000, regardless of your tax filing status and regardless of your income from other sources or lack thereof.

Example 1: George is a married joint-filer. In 2013, he earns a salary of $249,000. He has no other wage or SE income. His wife has no wage or SE income. George and his wife don't owe the 0.9 percent Medicare tax because they don't have wage or SE income in excess of the $250,000 threshold for joint-filing couples. Even so, George's employer must withhold the 0.9 percent tax on $49,000 (the excess of George's salary over the $200,000 withholding threshold). The withheld amount is $441 ($49,000 times 0.9 percent). When George and his wife file their 2013 federal income tax return, they will receive a federal income tax withholding credit for the $441 that was withheld.

There can also be situations where there is no wage withholding for an employee who does in fact owe the 0.9 percent tax.

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Example 2: Jill is a married-joint filer. In 2013, she earns a salary of $180,000. Her husband earns $140,000. Jill and her husband have no other wage or SE income. There is no employer withholding for the 0.9 percent tax because neither Jill or her husband have wage income in excess of the $200,000 withholding threshold. Nevertheless, they owe the 0.9 percent tax on $70,000 ($180,000 plus $140,000 minus the $250,000 joint-filer threshold), which amounts to $630. When Jill and her husband file their 2013 federal income tax return, the $630 will show up as an addition to their federal income tax liability.Additional withholding for the 0.9 percent tax starts with the pay period during which an employer pays an employee wages in excess of the $200,000 withholding threshold. When a payment causes the $200,000 withholding threshold to be exceeded, the additional withholding only applies to the portion of the payment that exceeds the threshold.Example 3: In 2013, Kent receives $170,000 of salary payments through November 30, 2013. On December 1, 2013, he receives an $85,000 bonus. The last $55,000 of the bonus payment is subject to withholding for the 0.9 percent tax. Kent's December salary payments are also subject to withholding for the 0.9 percent tax.

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What Kinds of Employee Compensation Are Subject to the Tax?

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The proposed regulations merely say the new 0.9 percent Medicare tax applies to "wages" in excess of the applicable threshold ($200,000, $250,000 or $125,000, whichever applies). However, IRS Frequently Asked Questions on the tax provide the following specifics.

Taxable fringe benefits - Your employer must withhold for the new 0.9 percent tax when your total wages--including the value of any taxable noncash fringe benefits that are treated as wages for federal employment tax purposes--exceeds $200,000. Examples of taxable fringe benefits include the value of personal use of a company car and company-paid club memberships. Group-term life coverage in excess of $50,000 - The imputed value of group-term life insurance coverage in excess of $50,000 is subject to the Social Security and the "regular" Medicare tax under longstanding rules. The imputed value is also subject to withholding for the new 0.9 percent Medicare tax to the extent the imputed value -- when combined with other amounts treated as wages for federal employment tax purposes -- exceeds the $200,000 withholding threshold.

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Third-party sick pay - Wages paid by an employer and by the third party must be aggregated to determine whether the $200,000 withholding threshold for the new 0.9 percent tax is met. The same rules that assign responsibility for sick pay reporting and withholding for purposes of the "regular" Medicare tax also apply for purposes of the new 0.9 percent tax.

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Do You Have Both Wage and Self-Employment Income?

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If you have both wage income subject to federal employment tax withholding and net SE income subject to the SE tax, take the following steps to determine how much, if anything, you owe for the new 0.9 percent Medicare tax

Step 1: Calculate the 0.9 percent tax on any wages in excess of the applicable threshold ($200,000, $250,000 or $125,000, whichever applies to you).

Step 2: Reduce the applicable threshold (but not below zero) by the total amount of your wages that are subject to the "regular" Medicare tax.

Step 3: Calculate the 0.9 percent tax on your net SE income in excess of the reduced applicable threshold calculated in Step 2.

The following examples illustrate how this three-step drill works.

Example 4: Linda is unmarried. For 2013, she has $160,000 of wages subject to the "regular" Medicare tax. Because her wages are below the $200,000 withholding threshold for the 0.9 percent Medicare tax, Linda's employer does not withhold anything for the 0.9 percent tax.Linda also has net SE income of $140,000 from a very profitable side business. To calculate the 0.9 percent Medicare tax on her SE income, the $200,000 applicable threshold for unmarried individuals is reduced by Linda's $160,000 of wages, resulting in a reduced threshold of $40,000 ($200,000 minus $160,000). Therefore, Linda owes the 0.9 percent tax on $100,000 of SE income ($140,000 minus $40,000 reduced threshold), which will increase her 2013 federal income tax bill by $900.

Example 5: Mark and Mary are married joint-filers. In 2013, Mark has wages subject to the "regular" Medicare tax of $190,000. Because his wages are below the $200,000 withholding threshold for the 0.9 percent Medicare tax, Mark's employer does not withhold anything for it.Mary has net SE income of $210,000. To calculate the 0.9 percent Medicare tax on Mary's SE income, the $250,000 applicable threshold for joint-filing couples is reduced by Mark's $190,000 of wages, resulting in a reduced threshold of $60,000 ($250,000 minus $190,000). Therefore, Mark and Mary owe the 0.9 percent tax on $150,000 of SE income ($210,000 minus $60,000 reduced threshold), which will increase their 2013 federal income tax bill by $1,350.

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