Health Care Reform's Effect on Your Taxes (Part I)
Many people are wondering how the new taxes related to Health Care reform will affect them. In one way or another, this new bill will touch virtually everyone. For some, the impact will be significant. The next few posts will focus on these new provisions, and whom they will affect.
The first thing that is important to understand is that the most significant tax changes that come from this new law will not take effect until 2013 – so there is still a little over two years before they will have a direct impact on your bottom line. Perhaps more significantly, we have two elections that will take place between now and 2013. Based on what has happened in the past, the results of those elections could impact the law itself, and change the way it currently stands. I will focus, though, on how the law is currently written, and what impact it will have if it remains unchanged.
The most significant effect of the new law
The key revenue raiser in the bill, and the focus of my attention in this first post, is the Medicare surtax. There are actually two surtaxes. The first one is an additional 0.9% tax on all wages and self-employment income (earned income) over a certain threshold. The second is an additional 3.8% tax on unearned income.
Example: Bob is a single, self-employed investment advisor. He also spends a lot of time working on his own investment portfolio. At the end of the year he has a total income of $300,000 – $250,000 from his business and $50,000 from his investments. The impact of the new law on Bob will be:
- $450 surtax on his self-employment earnings over the threshold
- $1,900 surtax on his unearned investment income
The first surtax of 0.9% of earned income (wages & self-employment) will affect single filers on all income above $200,000, and income over $250,000 for married couples who file a Joint return (note the hefty marriage penalty). There are two very important things to make a note of with this part of the surtax. First, the thresholds are based on earnings, not on AGI (adjusted gross income) or on taxable income. This distinction between earnings and AGI or taxable income can mean a significantly higher tax. Second, for those who have self-employment income, this surtax is not deductible as part of the usual ‘for AGI’ deduction of ½ of the self-employment tax.
The second surtax is an additional tax of 3.8% on unearned income. This is a very significant shift in the tax rules. It is important to understand that up to this point, Medicare and Social Security taxes have only applied to earned income. This new tax will apply to unearned income, such as interest, dividends, capital gains, rental income, royalties and non-qualified annuities. It will not apply to income from retirement plan distributions (IRAs, 401(k)s, etc.) or to tax-exempt interest.
This second surtax will be levied on taxpayers with a modified AGI greater than $200,000 for single, or $250,000 for married. The 3.8% tax is applied to the smaller of net investment income, or the amount of AGI over the threshold. So, if a couple had an AGI of $280,000, and an investment income of $35,000, the 3.8% tax would be on $30,000 ($280k AGI – $250k threshold). If a single individual had an AGI of $230,000 and an investment income of $10,000, the levy would apply to the $10,000 of investment income.
Depending upon what congress does with the future tax laws, there could be an especially heavy impact on Capital Gains income and, even more so, on Dividend income. President Obama’s plan is to increase the maximum capital gains tax to 20%, and dividends to 39.6%. With this surtax on top, those taxes would be 23.8% and 43.4% – almost double and triple where they currently stand at 15%.
As you can see, for those whose income is above $200-250,000, this new tax will have a noticeable effect on their marginal income. It will be worth including these changes in your long-term tax planning. That planning should give extra attention to the portions of income that come from dividends, self-employment income and tax-exempt interest.
Still haven’t had enough? Check out Part 2, Part 2 ½, and Part 3.
Special note: This post is intended to report the factual impacts of the Health Reform bill as it now stands. There is no intention in my writing to make commentary on the ‘rightness’ or ‘wrongness’ of the bill, or to insert a political undertone. Please do not interpret my writing in such a way. There are many strong feelings about this bill, but please do not turn the ‘comment’ section of this post into a political debate. Thanks!
I understand your not trying to make this political but this isn’t directed at the general public because most Americans like 98% don’t makeore than $200k per year. I think you might want to focus on how this bill will help the majority of Americans
It’s true that most Americans don’t fall into the 200k+ range. Other parts of this discussion on the tax implications of the health care reform bill may cover a wider audience.
In the Tax InSight course we discuss different types of income. One big topic we hit was the difference between earned and unearned income. This health care reform bill represents a big shift in the treatment of unearned income. It’s significant in that it signals perhaps a mental shift for lawmakers where they’ve begun crossing over to the “unearned side” to tap more revenue.
Only time will tell of course. But this in and of itself is significant for that reason — even if the group to whom it (now) applies is small.
In addition to the point that Jesse made, I will also add that the full focus of this site – the course, the book and the blog – is on taxes. To write about how the bill will benefit Americans would be completely off topic. Our purpose is to educate readers about one of the most significant expenses throughout their lifetime, and hopefully help them minimize that expense within the bounds of the law. While this tax may not affect a large percentage of people (now), it will have a significant effect on some. In particular, it will affect those who have the greatest need for tax planning (and the greatest need for our service) because they pay far more taxes than anyone else. We are not worried about the 47% of people who pay no taxes – they don’t have a lot of need to plan, nor do they have need for this site.
In addition, to underscore what Jesse said, certain shifts in tax policy (such as employment taxes on unearned income) may not seem significant at the time they occur, but can prove to be monumental as time passes – affecting far more people than what was originally thought. In this particular bill, for example, the income thresholds are not indexed for inflation. Simply with the passage of time more and more people will find themselves paying this tax. The alternative-minimum tax is a prime example of how this happens. It was originally intended to affect a few thousand people. Now it affects millions – and would affect millions more each year without the last minute stop-gap legislation that is passed each December.
These posts will always focus on taxes, pure and simple. They will state the facts of how laws and regulations affect an individual’s tax picture. They will not address the question of whether or not a given reason for a tax is justifiable. We will leave that for the politically focused venues.
For now I’m content to understand what the tax impact will be….time will tell if there’s a benefit and where it falls.
47% of people pay no taxes? What is included in that statistic? Students/Children?
Jt
I think Casey is spot on in his focus. Those most affected by this bill are those who will end up paying for it. Casey’s analysis is also of interest to those, like me, who don’t make $200,000 a year but feel that it is immoral to use the power of government to force money from one group of americans to give them to another group. Like someone (I don’t remember who) said ” When you rob Peter to pay Paul, you’ll have Paul’s vote” and be that as it may it is still wrong.
JT: Both Casey and Jesse are correct. Most of these new taxes don’t affect you now, but they probably will in the future. The Alternative Minimum Tax was initiated in 1969 to catch NINETEEN people who found loopholes to pay no income taxes, usually by deducting donated art with grossly inflated value.
What’s more, these taxes are squarely hitting SMALL BUSINESS OWNERS who file their taxes as S Corps, so any money withheld for future investment, expansion, or loss prevention is going to be hit with much higher taxes. If you’re wondering why no one is hiring these days, this is it. Eating into profits has an exaggerated effect on income. Say you operate your business with a 15% profit margin. If your taxes are increased by 1%, your profit becomes only 14%, but the CHANGE in profits is almost 7% (1/15th). The taxes are even worse for those with smaller profit margins.
Other effects are punishment of unearned income, which is made by taking risks. If taking risks becomes less profitable, fewer people will do it. And this affects the ability of mutual funds, which means PENSION funds, to earn.
Could Casey ever give some advice for those people making above $200K a year, who are salaried employees and don’t have a lot of investment income? I heard a term for these people just last week – HENRY – High Earner Not Yet Rich. If you are a salaried employee versus self – employed and make over $200K – is there anything you can do to avoid the high taxes (besides mortgage interest, HSA, retirement contributions) to get your AGI down? I know some politicians like to use the class warfare to win votes and compare these HENRYS to Warren Buffett, but the truth of the matter is that these HENRYS stimulate the economy as well (though some politicians will try to make voters believe taxing people above this threshold won’t make an effect at all since the increased money spent on taxes would just sit in a person’s savings account and not stimulate the economy). I can tell you from personal experience – I canceled a vacation because I had to pay a high tax bill last year, when my paycheck becomes smaller due to higher taxes I will stop using my lawn service, depending on what I owe this next year will determine if I do some updating on my home. So in the end higher taxes drives me to do my own lawn, not go on vacation and live in an outdated home. It annoys me but doesn’t truly hurt me. Who is truly hurt? The lawn man who loses his job, the people in the travel industry who book less trips and the contractors who have less jobs. I wish more people would understand this reality. HENRYs are NOT Warren Buffett.
I think I am confused on what is “earned income” versus gross income, since “earned income” is not the same as AGI. Could someone explain?
Thanks so much.
Jennie,
Earned income is any income that comes from employment or from being actively engaged in a business, without taking any deductions. AGI is all sources of income added together, including unearned income (such as interest or dividends), minus any above-the-line deductions (anything listed on the second half of page 1 of Form 1040.) There is a thorough discussion of this in our book, and maybe I will write more about it in a future blog post. But for now, I hope that helps.