The Internal Revenue Service (IRS) recently issued final regulations on the 0.9% Medicare tax imposed on certain high-income taxpayers, which was adopted under the Patient Protection and Affordable Care Act (PPACA). The new Medicare tax affects individuals whose FICA wages exceed $250,000 for marrieds filing jointly, $125,000 for marrieds filing separately, and $200,000 for singles and heads of household. The tax went into effect in 2013, and the final regulations took effect November 29, 2013.
Additional Medicare tax
Employers pay FICA taxes on the wages paid to employees during the year. FICA taxes also apply to nonqualified deferred compensation, with taxes often being due well before distributions are made.
FICA taxes are composed of two parts:
- The Old Age, Survivors and Disability Income (OASDI) tax, which is 6.2% on earnings up to the annual Social Security wage base ($117,000 for 2014)
- The hospital insurance (HI) tax for Medicare, which is 1.45% on all earnings (i.e., there is no cap)
The employee pays FICA taxes on wages at the same rates as the employer, and the employer withholds and remits the employee portion to the government. The employer generally is liable for FICA taxes whether or not the correct amounts were withheld from the employee’s wages.
The PPACA increased the HI portion of the tax to help finance health care reform. Effective in 2013, the law increases the HI employee portion (but not the employer portion) of the Medicare tax by 0.9% on FICA wages in excess of the income thresholds noted above. These dollar thresholds are not indexed for inflation.
Unlike the general 1.45% HI tax on wages, which applies only to the employee’s wages, this new Medicare tax and its dollar threshold apply to the combined wages of the employee and the employee’s spouse (assuming a joint return). However, the law requires the employer to withhold the additional Medicare tax only for employees whose wages exceed $200,000 from that employer for the year, regardless of the spouse’s earnings. This means the employee will be liable to the IRS for the additional 0.9% HI tax on any amounts owed that were not withheld by the employer.
The final IRS regulations provide rules to guide employers in computing, withholding, reporting and paying the new Medicare tax on wages. Following are some of the key issues that employers should be aware of regarding the new rules.
Employer’s obligation to withhold
Employers must start the additional withholding in the first pay period in which wages exceed $200,000, and the withholding applies only to pay in excess of the dollar threshold. The regulations reiterate that employers cannot take into account the employee’s filing status, or other wages or compensation (e.g., wages received by the employee’s spouse or from another employer). Employees who expect to owe more tax than the employer is withholding may submit IRS Form W-4 to increase the amount withheld or make estimated tax payments.
Calculating the tax
The timing of the tax calculation is no different from that for any FICA taxes, which is generally when wages are paid. For amounts set aside under a nonqualified deferred compensation plan, “special timing rules” apply:
- The general requirement for such plans is to take FICA wages into account under the special timing rule when earned and vested. In that case, the additional Medicare tax is taken into account at the same time.
- An employer can elect to use an alternative timing rule for non-account balance plans, such as a defined benefit supplemental executive retirement plan (SERP). Under this alternative, the entire value of a nonqualified deferred compensation benefit is taken into account when an employee retires. That present value also will be used to determine whether FICA wages for the year of inclusion exceed the dollar threshold, subjecting all or part of the nonqualified benefit to the additional Medicare tax.
Executives whose employers take the second approach will have new tax-planning considerations. On the one hand, they might consider retiring early in the year to avoid owing the additional 0.9% Medicare tax on all the deferred compensation paid to them, since they will be more likely to be under the income threshold for the year.
On the other hand, taking that distribution earlier could expose the nonqualified benefit to the larger 6.2% OASDI tax if total FICA wages are less than the taxable wage base, which might encourage retirement later in the year. The best tax scenario will depend on the individual’s facts and circumstances. Other strategies for minimizing the Medicare tax might also be useful, such as using the Section 3121(v) early-inclusion rules so that the tax is applied in years when the employee is under the threshold.
Under- and overpayments
The procedures to correct under- and overpayments of the additional 0.9% Medicare tax are more restrictive than those for other FICA taxes. Because the new Medicare tax has no employer portion, the tax liability must be reconciled with the amounts withheld on the employee’s income tax return. With some limited exceptions, this means that if an error is not caught in the same year wages are paid, the employer will need to inform the employee of the error (via a corrected W-2c), and the employee will need to file an amended return on Form 1040X to pay the additional tax or obtain a refund.
Especially for complex FICA tax determinations, such as those involving SERPs and certain other deferred compensation programs, employers should evaluate whether their current payroll processes could be improved upon to minimize such errors and the administrative complexities of needing to make corrections.
This article does not constitute consulting, legal, tax or any other type of professional advice, and should be used only in conjunction with the services of a Towers Watson consultant or another professional advisor with full knowledge of the user’s situation.