Most people don’t give a lot of thought to Medicare until they get ready to retire. However, if you are working and you get paid for it, you and your employer pay Medicare taxes on every dollar you earn. Over time, those Medicare taxes really add up.
Current tax law requires that wage earners pay 1.45 percent of their compensation in Medicare taxes. Employers are required to match that amount. No matter where you live, those taxes add up to big money. However, in California, where wages are higher than much of the rest of the country, the dollar burden of those Medicare taxes that much greater.
Medicare taxes are administered differently than social security taxes. Social security taxes stop accruing for the year after the wage earner earns more than the wage base limit ($147,000 in 2022). Medicare taxes, however, are levied on every dollar earned. Once income exceeds $200,000 ($250,000 for married-filing-jointly), there is an additional Medicare tax of 0.9 percent charged on every dollar earned above that threshold and a 3.8 percent surtax on net investment income. Employers are not required to match the additional Medicare tax or the surtax owed by employees.
To illustrate how large the tax burden will grow over a career, consider the situation of a person starting her career today earning $40,000 per year. If she receives a 3 percent increase in her salary each year and works for forty years, she and her employer will pay a combined total of $87,465 in Medicare taxes over the course of her career. If she started her career making $80,000 per year with the same percentage increase each year, she would pay $177,017—a little more than double the first example, because she would eventually become subject to the additional Medicare tax. The total tax burden could be greater if she had net investment income in the later years of her career.
Strategies to reduce Medicare tax liabilities generally center on two activities. First, reducing adjusted gross income below the surtax threshold. Second, reducing net investment income.
If you are an employee, one of the best ways to reduce your adjusted gross income is to maximize your contribution to your employer-sponsored retirement plan. While elective deferrals into a retirement account are still subject to social security and Medicare taxes, those deferrals may help keep your income below the threshold for the 0.9 percent additional Medicare taxes and the 3.8 percent surtax on net investment income.
If you are at a sufficient level in your company’s organization, you may be eligible to participate in a deferred compensation plan. Some deferrals may be excluded from Medicare taxes since deferred compensation plans require that you accept what the IRS calls “a substantial risk of forfeiture.” Business owners may gain additional relief by establishing a cash balance defined benefit plan. In both cases, consult with your fiduciary financial planner to make sure they make sense for you.
You can help minimize your exposure to the surtax on net investment income by engaging in an investment practice called tax-loss harvesting. Tax-loss harvesting involves selling assets at a loss to offset capital gains. It requires some extra work, but it can make a huge difference in your net after-tax returns. The 3.8% Medicare surtax is levied on net investment income so using tax losses to offset gains reduces your exposure to the Medicare surtax. A full description of this strategy is beyond the scope of today’s column, but your fiduciary financial advisor can help you design a strategy that is right for you.
You can also reduce your exposure to the Medicare surtax by donating your highly appreciated assets to your favorite charity. Donations-in-kind to non-profit organizations allow you to avoid taxes on capital gains, including the Medicare surtax. You also get a tax deduction for the value of your charitable gift. You can use the cash that would have gone to the charity to repurchase the assets you gave away. The net result is a portfolio with identical holdings but without the embedded capital gains and Medicare tax liabilities. This strategy would only be appropriate if you were interested in making charitable donations. Again, your financial advisor can help you determine if it is right for your situation.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to steve@montereypw.com.