A new Medicare tax goes into effect on January 1, and employers should review their deferred compensation arrangements to identify possibilities for tax savings by early payment of taxes in 2012. Additionally, a new Medicare surtax will be applied to all net investment income beginning in 2013. Compensation arrangements should be reviewed to minimize the affect of the new surtax charge.
Enacted as part of the health care reform law, beginning in tax years after 2012, a new additional .9 percent tax applies to FICA wages exceeding the following thresholds:
Click here to view table.
The new tax applies only to employees, not employers, although employers have withholding obligations. The same legislation also subjects unlimited amounts of net investment income that exceeds specified thresholds to a Medicare tax of 3.8 percent. The 3.8 percent Medicare Surtax applies to the lesser of (1) net investment income or (2) the amount by which modified adjusted gross income exceeds the threshold amounts in the chart above.
Before December 31, employees and employers should consider tax strategies for reducing the effect of the new Medicare taxes including:
- Accelerating income to 2012 that would otherwise be subject to the new tax rate in later years
- Redirecting income to the few types of income exempt from either of the new taxes
- Deferring for as long as possible income receivable after 2013 and not exempt from the new taxes. There are many possible approaches to minimizing the effect of the new Medicare tax. Highlighted below are some simpler concepts companies may want to consider.
Accelerating compensation income in 2012
Employers and employees may want to consider opportunities to accelerate wages and bonuses so that they are paid in 2012, rather than 2013. Not only will these wages and bonuses escape the additional Medicare tax, but will be subject only to the maximum 35 percent federal income tax versus a possible maximum of 39.65 percent in 2013, depending on Congressional and Presidential action in the coming weeks.
Early inclusion of deferred compensation for FICA
An alternative to early payment of bonuses or other deferred compensation is early payment of FICA. For example, 2012 bonuses which are paid early in 2013 could be electively included in FICA income for 2012 so long as the bonuses are vested, and the bonuses are paid by March 15, 2013 and so long as the elective early inclusion for FICA income relates to all employees covered under the plan.
Early payment of FICA taxes for defined benefit plans
Deferred compensation is not generally subject to Medicare until it is vested and ascertainable. For defined benefit plans, this means that Medicare tax often is not paid until an employee terminates employment, when the total value of the plan benefit is ascertainable. For defined benefit deferred compensation plans that currently have vested and accrued benefits, the employee can electively pay FICA taxes presently for vested, accrued benefits on an estimated basis. If such early elections are made in 2012, the additional Medicare tax can be avoided for amounts accrued and vested this year. Early FICA inclusion will also exempt the future value of that amount from any additional FICA tax, including the additional .9 percent rate applicable to years after 2012.
Early vesting of 457(f) plans
For deferred compensation plans of tax-exempt and governmental employers, subject to Code Section 457, early vesting in 2012 can avoid future increased Medicare tax rate. The general rule is that once an employee is vested in an amount payable under a 457(f) plan, those amounts are subject to full taxation, including income and FICA, even when the employee is not entitled to a distribution. An employer could choose to accelerate vesting of 457(f) amounts (though payment may not be accelerated), to enable the employee to pay 2012 Medicare and income tax rates.
The following chart shows how the new Medicare tax can affect the taxation of employee benefits and executive compensation:
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* Other than from sale of trades or business, provided that it is not a passive activity or trading in financial instruments
Note that the IRS is drafting proposed regulations on these new Medicare taxes, and that could possibly affect executive and deferred compensation plans and arrangements.