The recently enacted health-care reform legislation includes new Medicare-related taxes. These new taxes take effect in 2013, and target higher income individuals and families. While additional details and clarifications will become available between now and 2013, here’s what you need to know.
New additional Medicare payroll tax
If you receive a paycheck, you probably have some familiarity with the Federal Insurance Contributions Act (FICA) employment tax; at the very least, you’ve probably seen the tax deducted on your paystub. The old age, survivors, and disability insurance (“OASDI”) portion of this FICA tax is equal to 6.2% of covered wages (up to $106,800 in 2010). The hospital insurance or “HI portion” of the tax (commonly referred to as the Medicare payroll tax) is equal to 1.45% of covered wages, and is not subject to a wage cap. FICA tax is assessed on both employers and employees (that is, an employer is subject to the 6.2% OASDI tax and the 1.45% HI tax, and each employee is subject to the 6.2% OASDI tax and the 1.45% HI tax on wages as well), with employers responsible for collecting and remitting the employees’ portions of the tax.
Self-employed individuals are responsible for paying an amount equivalent to the combined employer and employee rates on net self-employment income (12.4% OASDI tax on net self-employment income up to the taxable wage base, and 2.9% HI tax on all net self-employment income), but are able to take a deduction for one-half of self-employment taxes paid.
Beginning in 2013, the new health reform legislation increases the hospital insurance (HI) tax on high-wage individuals by 0.9% (to 2.35%).
Who’s subject to the additional tax?
If you’re married and file a joint federal income tax return, the additional HI tax will apply to the extent that the combined wages of you and your spouse exceed $250,000. If you’re married but file a separate return, the additional tax will apply to wages that exceed $125,000. For everyone else, the threshold is $200,000 of wages. So, in 2013, a single individual with wages of $230,000 will owe HI tax at a rate of 1.45% on the first $200,000 of wages, and HI tax at a rate of 2.35% on the remaining $30,000 of wages for the year.
Employers will be responsible for collecting and remitting the additional tax on wages that exceed $200,000. (Employers will not factor in the wages of a married employee’s spouse.) You’ll be responsible for the additional tax if the amount withheld from your wages is insufficient. The employer portion of the HI tax remains unchanged (at 1.45%).
If you’re self-employed, the additional 0.9% tax applies to self-employment income that exceeds the dollar amounts above (reduced, though, by any wages subject to FICA tax). If you’re self-employed, you won’t be able to deduct any portion of the additional tax.
New Medicare contribution tax on unearned income
Beginning in 2013, a new 3.8% Medicare contribution tax will be imposed on the “unearned income” of high-income individuals (the new tax is also imposed on estates and trusts, although slightly different rules apply). The tax is equal to 3.8% of the lesser of:
Your net investment income (generally, net income from interest, dividends, annuities, royalties and rents, and capital gains, as well as income from a business that is considered a passive activity or a business that trades financial instruments or commodities), or your modified adjusted gross income (basically, your adjusted gross income increased by any foreign earned income exclusion) that exceeds $200,000 ($250,000 if married filing a joint federal income tax return, $125,000 if married filing a separate return).
So, effectively, income is subject to the additional 3.8% tax if your adjusted gross income exceeds the dollar thresholds listed above. It’s worth noting that interest on tax-exempt bonds, veterans’ benefits, and excluded gain from the sale of a principal residence that are excluded from gross income are not considered net investment income for purposes of the additional tax. Qualified retirement plan and IRA distributions are not considered investment income.
Together, these two new Medicare-related taxes are expected to provide a major source of revenue to finance other parts of health-care reform. The Joint Committee on Taxation projects that the combined revenue attributable to these two new taxes will exceed $210 billion over the ten-year period ending in 2019.
What are the implications for private clients?
The rate increases alone are made much more significant because they follow the expiration of 2001 tax cuts, meaning that the rates will nearly triple on certain investment returns. Taxable portfolios will naturally be affected, but because nearly half the assets invested in the US are in taxable portfolios, this is likely to exert a certain inertia all investment portfolios.
In particular, the higher rates of taxation will make dividend paying common stocks and preferred stocks generally less attractive in taxable accounts. Between now and 2013 the top federal tax on qualified dividends will increase from 15% to 43.4%. Over the same period, the top rate of taxation on corporate, foreign and federal government bonds will increase from 35% to 43.4%. Federal capital gains taxes are also increased by the new taxes. The top capital gains rate will increase from 15% currently to 23.8% in 2013.
From an overall asset allocation standpoint, this enhances the existing conditions already making equities the preferred investment for taxable portfolios, and fixed income the desired alternative for tax deferred accounts (like IRAs, 401(k)s, Deferred Comp plans). But, because the current interest rates delivered by most government fixed income instruments are so much lower than any reasonable long term (or even short term) expectations of stock market returns, a client’s target asset allocation shouldn’t necessarily be significantly different than under the current tax environment. However, what types of securities are purchased to fill out that “high level” asset allocation are another matter entirely.
Assuming that all of these tax increases are realized in the coming years, the bias should be overall towards growth stocks, particularly those of smaller growth companies. The management teams of these companies generally retain earnings, making the nature of their returns more tax efficient because they will come from capital gains, as opposed to dividends. Growth companies are also considerably less dependent upon bond issuances to finance their capital structure, meaning that increasing interest rates (driven by higher taxes to the buyers of those bonds) will have a less significant impact on their profitability.
Historically, international and emerging markets’ stocks have paid higher dividends, making them less attractive in a taxable accounts versus US stocks. Our bias is already towards the US for other factors, but this reinforces our perspective.
Because of the historically tax inefficient approach of active mutual funds and hedge funds, these investments are even less attractive relative to index funds and index tracking exchange traded funds. It’s also likely to expect that these managers will adjust their strategies to adapt to the new tax regime, potentially reducing their pre-tax rates of return.
On the fixed income side, municipal bonds, because of their federal tax free returns, become more attractive relative to federal government, corporate and high yield bonds in taxable accounts. Inside of tax deferred accounts, municipal bonds aren’t an appropriate investment, but federal government bonds –because of their low rates of interest and the fact that they are exempt from state and local income taxes will be less attractive than high quality corporate or foreign dollar denominated bonds.
How likely is it that these increased tax rates will actually be imposed?
This is an extremely difficult question to answer, but we expect that they will materialize. While there is a possibility of some ‘grandfathering’ of the 2001 tax rate reductions, these are generally unlikely to be realized by our clients, as the emphasis is likely to be on lower income earners. Given the extremity of the fiscal deficits being experienced by major state, local and the federal governments, there will be a voracious demand for tax revenue in the next few years.
The fact that the Democratic leadership and the President have indicated their opposition to the 2001 legislation originally cutting taxes, and the hostile political environment in Congress, a compromise seems unlikely. Even in the event that Republican majorities take control of both houses in November, the existence of a Presidential veto and the direness of the nation’s finances make ‘tax cuts’ difficult.
While the last several months have indicated that nothing is a given in American politics, prudence dictates viewing dramatic tax increases in the future as an inevitability. In short, we should hope for the best, but prepare for the worst.
Over the course of the last few years, we’ve generally favored growth stocks, but been loathe to realize capital gains to reallocate most taxable portfolios. In 2010, we’re increasingly predisposed to realize gains on the expectation that paying now is preferable to paying later. Consequently, as 2010 is the last year of the “old regime”, we’ll be selling more stocks with gains to position portfolios for higher taxes in the coming years.