The federal Medicare program offers helpful medical benefits for retired individuals. Of course, those benefits must be funded in some way, hence the Medicare tax.
Let’s talk about what the Medicare tax is, what it helps fund, and what kind of Medicare taxes you may be paying.
The Medicare Tax Defined
The Medicare tax is also referred to as the “hospital insurance tax” and is a federal employment tax that is taken directly out of your W2 paycheck. If you’re self-employed, you will pay for this tax when you submit your quarterly or annual taxes.
The Medicare tax pays for Medicare Part A, which is the part of Medicare that covers inpatient hospital stays, nursing home care, and some home healthcare. This includes individuals who are part of the Medicare program because they are 65 or older, have End-Stage Renal Disease, or are on Medicare due to disability.
How the Medicare Tax Works
The Federal Insurance Contributions Act (FICA) made it a requirement that all employers withhold Social Security and Medicare taxes from their employee’s paychecks. The Self-Employed Contributions Act (SECA) mandated the same thing for individuals who are self-employed.
The Social Security and Medicare taxes that are collected from individuals are placed into trust funds that are held by the United States Treasury. The Medicare tax is held in the Hospital Insurance Trust Fund. Money in this fund is then used to pay for Part A expenses incurred by Medicare beneficiaries.
Medicare taxes and Social Security taxes are put into trust funds held by the U.S. Treasury. Medicare tax is kept in the Hospital Insurance Trust Fund and is used to pay for Medicare Part A.
Expenses incurred for Part B and Part D are taken from the Supplemental Medical Insurance Trust Fund. That trust fund is funded with premiums from Medicare beneficiaries, tax revenues, and investment earnings.
The money that accumulates in both of these trust funds is intended to be used on both current and future Medicare beneficiaries. However, there are some solvency concerns and budget issues with the Hospital Insurance Trust Fund, and it is expected to be depleted by 2026. This could greatly impact the Medicare program unless lawmakers find other ways to finance Medicare benefits.
Part of the problem was exacerbated by the Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020. This act helped cover individuals who were affected by the COVID-19 pandemic, regardless of if they were enrolled in Medicare. There were more payments for hospital stays and durable medical equipment coming out of the Hospital Insurance Trust Fund.
Medicare Tax Rates in 2021
The current Medicare tax rate is 2.9%. This percentage is split 50/50 between employer and employee unless the individual is self-employed. In that case, they are responsible for the full rate. There is no income limit on Medicare taxes as there is on the Social Security tax.
Wages that are subject to the Medicare tax include regular wages, tips, bonuses, commissions, vacation allowances, etc.
Two Medicare Surtaxes
The Affordable Care Act (ACA) of 2013 brought two Medicare surtaxes into the equation. This was done in the hopes of expanding the Medicare program. These two surtaxes are the additional Medicare tax and the net investment income tax. These apply to high-income earners and are specific to types of income. Some individuals may end up paying both of these surtaxes.
The Additional Medicare Tax
The additional Medicare tax is applied to people who earn income over a certain threshold. The income includes any wages, self-employment income, and compensation. In 2021, this threshold was $200,000 for individuals and $250,000 for couples who file taxes jointly.
The additional Medicare tax rate is 0.9% in 2021. This additional Medicare tax is also taken directly from an employee’s paycheck or paid as part of the self-employment taxes. However, it does not apply to the employer, so the employee is responsible for the full amount.
The Net Investment Income Tax
The net investment income tax is also referred to as the “unearned income Medicare contribution surtax.” This extra Medicare tax applies to net investment income and is a rate of 3.8% and applies to dividends, taxable interest, capital gains, rental income, and nonqualified annuities. It does not include any income that was previously excluded, like tax-exempt municipal bond interest.
The tax will be applied to an individual’s net investment income or the excess modified adjustment gross income (MAGI) that is over certain thresholds, whichever is less.
This tax is paid completely by the employee.
For example, let’s pretend you are a married person who files jointly, and you and your spouse had a combined income of $230,000. You also earned $70,000 in investment income, which means your total MAGI is $300,000. The threshold for married couples filing jointly is currently $250,000. You will be required to pay the 3.8% net investment income tax on the less of the excess MAGI ($50,000 in this case) or the total amount of investment income ($70,000 in this case). Since the excess MAGI is less, you would pay 3.8% on the $50,000, which amounts to $1900.
There’s a reason why they say death and taxes are the only certainties in life. However, we all hope to benefit from the Medicare program when we get older, so you will see the returns of your taxes later in life! If you have questions about your taxes, discuss this with your accountant.