Healthcare Reform: Increased Taxes for Individuals and Important Changes

April 1, 2010

As a result of the new health reform package, there are many changes affecting individuals and businesses. While you have no doubt read bits and pieces of the items included, below is a brief overview of key tax changes affecting individuals, particularly high income individuals, who will be burdened with additional taxes being phased in over the next several years.  

The new law contains "individual mandate", which becomes effective in 2014. This is the requirement that U.S. citizens and legal residents have qualifying health coverage or be subject to a tax penalty after 2013. Under the new law, those without qualifying health coverage will pay a tax penalty of the greater of: $695 per year, up to a maximum of three times that amount ($2,085) per family, or 2.5% of household income over the threshold amount of income required for income tax return filing. The penalty will be phased in according to the following schedule: a flat rate of $95 in 2014, $325 in 2015, and $695 in 2016 or 1.0% of taxable income in 2014, 2.0% of taxable income in 2015, and 2.5% of taxable income in 2016. Beginning after 2016, the penalty will be increased annually by a cost-of-living adjustment. There are exemptions for financial hardship, religious objections, and others specified in the new regulations.

Higher Medicare payroll tax on wages. The Medicare payroll tax is the primary source of financing for Medicare's hospital insurance trust fund, which pays hospital bills for beneficiaries who are 65 and older or disabled. Under current law, wages are subject to a 2.9% Medicare payroll tax. Workers and employers pay 1.45% each. Self-employed individuals pay both halves of the tax (but are allowed to deduct half of this amount in arriving at their adjusted gross income. Unlike the payroll tax for Social Security, which applies to earnings up to an annual ceiling ($106,800 for 2010), the Medicare tax is levied on all of a worker's wages without limit. Under the provisions of the new law, which take effect in 2013, most taxpayers will continue to pay the 1.45% Medicare hospital insurance tax, but single people earning more than $200,0000 and married couples earning more than $250,000 will be taxed at an additional 0.9% (2.35% in total) on the excess over those base amounts. Self-employed persons will pay 3.8% on earnings over the threshold.

Medicare payroll tax extended to investments. Under current law, the
Medicare payroll tax only applies to wages. Beginning in 2013, a Medicare tax will, for the first time, be applied to investment income. A new 3.8% tax will be imposed on net investment income of single taxpayers with AGI above $200,000 and joint filers over $250,000. Net investment income is interest, dividends, royalties, rents, gross income from a trade or business involving passive activities, and net gain from disposition of property (other than property held in a trade or business). Net investment income is reduced by properly allocable deductions to such income. However, the new tax won't apply to income in tax-deferred retirement accounts such as 401(k) plans.

Also, the new tax will apply only to income in excess of the $200,000/$250,000 thresholds. So if a couple earns $200,000 in wages and $100,000 in capital gains, $50,000 will be subject to the new tax. Another result of the changes will be that the effective capital gains tax rate will go from 15% to 23.8% (20% + 3.8%).

The floor on medical expenses deduction will be raised from 7.5% of adjusted gross income (AGI) to 10%. Under current law, taxpayers can take an itemized deduction for unreimbursed medical expenses for regular income tax purposes only to the extent that those expenses exceed 7.5% of the taxpayer's AGI. The new law raises the floor beneath itemized medical expense deductions from 7.5% of AGI to 10%, effective for tax years beginning after Dec. 31, 2012. The AGI floor for individuals age 65 and older (and their spouses) will remain unchanged at 7.5% through 2016.

The regulations limit reimbursement of over-the-counter medications from HSAs, FSAs, and MSAs. The new law excludes the costs for over-the-counter drugs not prescribed by a doctor from being reimbursed through a health reimbursement account (HRA) or health flexible savings accounts (FSAs) and from being reimbursed on a tax-free basis through a health savings account (HSA) or Archer Medical Savings Account (MSA), effective for tax years beginning after Dec. 31, 2010.

The new law increases the tax on distributions from a health savings account or an Archer MSA that are not used for qualified medical expenses to 20% (from 10% for HSAs and from 15% for Archer MSAs) of the disbursed amount, effective for distributions made after Dec. 31, 2010.

Flexible spending arrangements (FSAs) is one of a number of tax-advantaged financial accounts that can be set up through a cafeteria plan of an employer. An FSA allows an employee to set aside a portion of his or her earnings to pay for qualified expenses as established in the cafeteria plan, most commonly for medical expenses but often for dependent care or other expenses. Under current law, there is no limit on the amount of contributions to an FSA. Under the new law, however, allowable contributions to health FSAs will be capped at $2,500 per year, effective for tax years beginning after Dec. 31, 2012. The dollar amount will be indexed for inflation after 2013.

One change that takes effect this year is extending the general exclusion for reimbursements for medical care expenses under an employer-provided accident or health plan to any child of an employee who has not attained age 27 as of the end of the tax year. This change is also intended to apply to the exclusion for employer-provided coverage under an accident or health plan for injuries or sickness for such a child. A parallel change is made for VEBAs and 401(h) accounts. Also, self-employed individuals are permitted to take a deduction for the health insurance costs of any child of the taxpayer who has not attained age 27 as of the end of the tax year,

While some of these changes are effective immediately, most are not going to be applied for several years. Further and possibly extensive changes are anticipated, however, this represents the current information. We will be advising you on the changes as they become available. One thing is obvious, taxes on high income earners is increasing, making year-round planning even more essential. Contact your PerelsonWeiner partner to make sure you are doing all you can to maximize your personal situation.

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