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Expansion of Medicare taxes under healthcare legislation

Posted by Jamie Downey  March 18, 2010 08:34 AM

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Emerging from the health care reform legislation is a new expansion of the Medicare tax. This is in addition to the various other tax increases included in the legislation. Since the inception of Medicare, taxes have been assessed on wage earners to fund the program. The current Medicare tax rate is 2.9 percent for all wages earned. Under the proposed health care legislation, this Medicare tax will now expand and be assessed on investment income. Investment income includes dividends, interest, rental income and capital gains. Initially, it will be targeted at families with adjusted gross income (AGI) over $250,000 and single individuals with AGI's over $200,000. Earn one dollar in excess of $250,000 and you will be assessed this tax on each dollar of investment income.

With many of the "Bush" tax cuts set to expire at the end of this year, there are going to be serious changes in the tax code. Dividends are currently taxed at a maximum rate of 15 percent. Starting next year this will increase to a maximum rate of 39.6 percent. Should this new legislation pass, the maximum tax rate on dividends will increase to 42.5 percent. Add on Massachusetts state tax of 5.3 percent and the maximum effective tax rate on dividends will be 47.8 percent. States such as California will have a tax rate over 50 percent. This is a pretty big swing from the 2009 tax rate.

Even those that are not in the upper brackets will feel the effects of this tax as companies will be less likely to pay dividends. While it may not seem outrageous to charge this level of tax on dividends, one must understand that dividends are already taxed at the corporate level, thus are subject to double taxation. Let's consider a corporation that is subject to the maximum federal corporate tax rate of 35 percent and the Massachusetts corporate tax rate of 9.5 percent. This creates a combined effective rate of approximately 45 percent. For each $1,000,000 of profit that the corporation earns, it will pay approximately $445,000 in federal and state taxes. Assume the corporation then chooses to pay the remaining $555,000 in a dividend. This dividend will then be taxed as income to the individual recipient. If the individual is assessed at the maximum tax rate of 47.8 percent, this will yield another $265,000 in taxes paid. Of the original $1,000,000 of income earned, only $290,000 will reach the shareholder after taxes paid. This creates a marginal effective tax rate of 71 percent for corporate earnings.

There is no doubt that dividend payouts will decline as a result of these levels of taxation. What is the incentive to earn money for shareholders if seven out of ten dollars will go to pay taxes? Maybe Governor Patrick told President Obama about the wonders that double taxation is doing to the Massachusetts economy. Last year the Governor enacted a sales tax on the existing excise tax for various addictive products, i.e. alcohol and tobacco.

The Wall Street Journal reported that this tax will raise $183.6 billion over ten years. Furthermore, 86 percent of the revenue generated from this tax will fall on 1.2 million tax payers. This amounts to $132,000 per capita tax increase on those 1.2 million families. Coupled with the expiring tax deductions this year and other increases Mr. Obama is proposing on high wage earners and you have an all out assault on a small number of persons.

I have to ask why the Massachusetts delegation (with the exception of Senator Brown) is so in favor of this legislation. Massachusetts already has mandated health care. Recent reports note that 97 percent of our citizens are covered by health insurance. Furthermore, as a state we will pay a disproportionate amount of the new taxes under this bill. Massachusetts citizens earn more money than the national average. As a percentage of taxpayers, Massachusetts has approximately 50 percent more families with an AGI over $250,000 than the national average. Massachusetts citizens will not see any tangible change in benefits. However, we will certainly feel the burden of the increased taxes in this legislation.

Whether this legislation passes or not, Medicare will continue to hemorrhage cash for the foreseeable future. This can only result in future tax increases. The biggest concern to the expansion of the Medicare tax is that the genie will be out of the bottle. Over time, you can be sure that the $250,000 threshold for implementing this tax will be lowered and ensnare more tax payers.

This blog is not written or edited by Boston.com or the Boston Globe.
The author is solely responsible for the content.

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D. Abraham Ringer is a CERTIFIED FINANCIAL PLANNER practitioner and a Financial Adviser with Morgan Stanley Global Wealth Management in Boston. He is registered in MA, NH, NY and several other states to which his articles are directed. For more information please visit www.morganstanleyfa.com/ringer
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