Medicare tax is a federal employment tax that is used to fund a portion of the Medicare insurance program for people 65 or older.
The current Medicare tax is 2.9% on all earned income, but W2 employees split the cost with their employer and pay 1.45% each. Self-employed folks are responsible for paying both portions of the Medicare tax.
Medicare tax is part of payroll taxes, along with Social Security tax, that employers typically withhold (together they are known as FICA taxes). However, unlike the Social Security tax, there is no income cap for Medicare tax and all earned (ordinary) income such as salary, tips, bonuses, and commissions will be subject to the tax, regardless of amount.
For high-income earners, the Affordable Care Act (ACA) in 2013 introduced two additional Medicare surtaxes that increase their taxes:
- An additional Medicare tax on earned income over a certain limit (0.9%)
- Net Investment Income Tax (or NIIT) on net investment income (3.8%)
Additional Medicare Tax On Earned Income (0.9%)
High-income earners not only pay the base 1.45% Medicare tax rate (or 2.9% if self-employed) up to a certain income limit (shown below) but also pay an additional 0.9% Medicare tax on income above the limit.
- For example, based on the current income limits for a couple making $300,000 a year working for a corporation, the first $250,000 is taxed at 1.45% (or $3,625, with their employer paying the other half) and the remaining $50,000 is taxed at 2.35% (1.45% + 0.9% or $1,175) for a total of $4,800 in Medicare taxes. In most cases, this is withheld automatically from their paychecks.
- For a self-employed couple making $300,000, they would pay 2.9% on the first $250,000 (or $7,250, since they are their own employer) and 3.8% on the remaining $50,000 (2.9% + 0.9% or $1,900) for a total of $9,150 in Medicare taxes which they are responsible for withholding and paying themselves.
| Tax Filing Status | Annual Income Limit (Before Additional 0.9% Medicare Taxes) |
| Married Filing Jointly | $250,000 |
| All Others (Including Single Filers) | $200,000 |
Source: IRS; 2023 tax year
Net Investment Income Tax (NIIT) (3.8%)
Additionally, high-income earners must pay the 3.8% NIIT above a certain amount of total income (MAGI for tax purposes). You pay the lesser of 3.8% on your total net investment income or income over the 200K singles and 250K married couples limits.
- For example, a married couple that earns $300,000 in combined salary along with $50,000 of net investment income would have a total taxable income of $350,000.
- Since the NIIT income limit for a couple is $250,000, an additional 3.8% NIIT is due on the lesser of net investment income ($50,000) or taxable income above the $250K limit ($100,000). In this case, they would pay NIIT of $1,900 on their net investment income (3.8% x $50,000).
Net investment income includes not only capital gains (short and long-term) but all other “unearned income” such as dividends (qualified and nonqualified), interest, nonqualified annuities, and rental income which are not “earned” income such as salary from a job. Excluded from the NIIT is any tax-exempt income such as interest from a municipal bond.
If you qualify for lower long-term capital gains (LTCG) tax rates (compared to ordinary income tax rates and only on long-term capital gains and qualified dividends), the NIIT increases part of the 15% (to 18.8%) LTCG tax bracket and the entire 20% (to 23.8%) LTCG tax bracket.
Thus, high-income earners will have to pay the additional NIIT on top of their LTCG taxes for their long-term capital gains and qualified dividends if their total income is over the 200K singles and 250K married couples limits.
Source: IRS; 2023 tax year
Save Money By Tax Planning
High-income earners should realize they are being penalized for making over $200,000 a year as a single individual and $250,000 a year as a married couple with the additional Medicare tax and NIIT. The marriage penalty here is obvious as the income limit for a married couple is just $50K more than an individual.
As a THR reader, your goal is to make as much passive investment income as possible, since it will be taxed at lower rates compared to actively earned income from a job. Making enough passive investment income to support your lifestyle means you’ve achieved a monumental financial milestone: financial freedom.
While avoiding the additional 0.9% Medicare tax on earned income is difficult if you are working a career, you can incorporate strategies into your tax planning to reduce the 3.8% NIIT. If your taxable income is high enough to go over the NIIT income limits, here are some thoughts to keep taxable income as low as possible:
- Max out your contributions to qualified retirement accounts that lower your MAGI like a 401k or deductible Traditional IRA (although high-income earners will likely only qualify for a non-deductible IRA).
- Contribute to other pre-tax accounts like a Flexible Spending Account or a Health Savings Account (the ultimate tax-saving investment account).
- Use your employer-sponsored pre-tax Cafeteria Plans to pay for expenses like health insurance, life insurance, and long-term disability insurance (It’s so important to have your own LTDI if you’re not financially independent).
- Shifting some investments to ones that produce tax-exempt income such as municipal bonds which lowers your MAGI.
- Rebalance your investment portfolio to emphasize growth stocks over dividend-paying stocks which are taxed more heavily as a result of the NIIT.
- Defer capital gains on existing investments into the future and plan around taking large capital gains. Capital gains are only subject to the NIIT when investments are sold and can be offset by capital losses (a tax saving strategy known as Tax Loss Harvesting), which dividends cannot be.
While tax laws are complex and constantly changing, for high-income earners it’s wise to invest time thinking about tax planning as taxes will be your biggest ongoing expense.
I’ve been able to use strategies such as tax-arbitraging to reduce cost of living and aggressively save towards financial freedom.
Only you know your own financial situation (I can’t give you any tax advice), so do your own research or speak to a CPA when making financial decisions. That effort invested can save you thousands in taxes every year!