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CCH® PENSION — 04/08/10

Increased Medicare taxes imposed under health reform law will not be assessed on plan distributions

Provisions of the recently enacted health reform legislation (The Patient Protection and Affordable Care Act (P.L. 111-148)) that would impose additional Medicare payroll taxes on individual earned income and net investment income over $200,000 ($250,000 for joint filers) will not apply to elective contributions or to amounts earned on investments in 401(k) and other qualified plans.

Increased Medicare tax offsets cost of health reform

In order to finance health reform measures enacted in the new law, a 0.9 percentage point increase in the 1.45% Medicare payroll tax (to 2.35%) would, beginning in 2013, be imposed on individuals with earned income over $200,000 per year and joint filers with earned income over $250,000 per year. Note, the employer Medicare tax rate would remain unchanged at 1.45%.

Elective contributions (including Roth 401(k) contributions and additional voluntary contributions in excess of the deferral limits are subject to a two-part tax under the Federal Insurance Contributions Act (FICA). An Old-Age, Survivor, and Disability Insurance (OASDI) tax of 6.25% is assessed on covered wages, up to the applicable taxable wage base ($106,800 in 2010). In addition, a 1.45% Hospital Insurance (i.e., "Medicare tax") is imposed on covered wages, irrespective of the applicable wage base. Self-employed individuals are subject to a 2.9% tax on earnings up to the wage base.

Although elective contributions are generally subject to FICA tax, the additional 0.9% Medicare tax will not apply to such contributions, because the additional tax will only affect amounts in excess of the applicable threshold of $250,000 for joint filers and $200,000 for other taxpayers. As the applicable contribution limits under Code Secs. 402(g) and 415 do not allow for contributions of such magnitude, the additional 0.9% Medicare tax will not apply to elective contributions.

Reconciliation bill imposes additional Medicare tax on net investment income

The Health Care and Education Reconciliation Act of 2010 (enacted as a "sidecar" to move changes made by the House of Representatives to the Affordable Care Act to the Senate under budget reconciliation rules that allow for mere majority approval), effective January 1, 2013, imposes an additional 3.8% Medicare tax on investment income. The tax will be 3.8% of the lesser of net investment income or the excess of modified adjusted gross income over the threshold amounts of: $250,000 for joint filers, $125,000 for married individuals filing separately, and $200,000 for other taxpayers.

CCH Note: An open issue that may require clarification is whether the additional tax will be limited to net investment income in excess of the applicable thresholds, or whether the tax will be imposed on all investment income once the threshold is reached.

Net investment income would consist of interest, dividends, annuities, royalties, rents (other than income derived from any trade or business to which the tax does not apply), gross income from trade or businesses involving passive activities and net gain from the disposition of property (other than property held in a trade or business). Net investment income, however, could be reduced by deductions properly allocable to such income.

CCH Note: Gross income, for purposes of the increased Medicare tax, would not include: interest on tax-exempt bonds, veterans' benefits, and excluded gain from the sale or a principal residence, which are excluded from gross income for income tax purposes.

Increased assessment will not be imposed on plan distributions

The expanded scope of the Medicare tax under the health reform legislation had raised concern that other income that had not previously been subject to the tax, such as assets in an individual 401(k) account and plan investment income, would now be taxed as net investment income upon distribution. The American Society of Pension Professionals and Actuaries (ASPPA) has confirmed that the reconciliation measure excludes distributions from qualified retirement plans, such as 401(k) and pension plans, from the increased Medicare tax.

Thus, investment income generated on investments within the plan will not be subject to the new 3.8% Medicare tax on income in excess of the $200,000-$250,000 threshold limits.

CCH Note: A question that may need clarification is whether an annuity payment that does not represent a return on the investment in the contract would be subject to the additional tax as investment income.

For more information on this and related topics, consult the CCH Pension Plan Guide, CCH Employee Benefits Management, and Spencer's Benefits Reports.

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