The Affordable Care Act (ACA or ObamaCare) was an expensive bill. That meant that somebody was going to have to pay for it. So, Congress added two new taxes to pay the bill. As is typical, the narrative was that the tax would only be on The Rich. Thanks to no inflation adjustments to the income limits pertaining to these taxes and almost 12 years of the inflation; if you work after your military retirement, you might be one of The Rich. In other words, you'll probably get the opportunity to pay these taxes. If that's the case, it's probably best to understand them.
The Additional Medicare Tax
The Additional Medicare Tax is levied on wages. More specifically, Medicare wages. That means contributions to 401(k)s or TSP won't help you avoid this tax. The tax is 0.9% of the amount that exceeds the following limits:
Married Filing Jointly (MFJ): Wages in excess of $250,000
Married Filing Separately (MFS): Wages in excess of $125,000
All others (Single, Head of Household): Wages in excess of $200,000
If your Medicare wages exceed the thresholds, you're paying the tax. No way around it.
Employers are required to start withholding (0.9%) when wages exceed $200,000 regardless of your filing status. This means that if you file jointly (MFJ) and your wages are the only wages, your employer will "over-withhold" this tax. Not to worry though, the excess withholding will be applied towards your income tax reducing the amount you owe or increasing the amount of your refund.
Net Investment Income Tax (NIIT)
The NIIT is a little more complicated. Of course, that also normally means that there may be ways to reduce it.
The NIIT applies to investment income which the IRS defines broadly. It can include:
Interest
Dividends
Capital Gains
Rents
Income from partnerships where you don't actively participate
The income limits for the NIIT are similar to the Additional Medicare Tax, but not identical. In this case, the income limits are based on Adjusted Gross Income (AGI)...which will include your military pension. So, you might not be subject to the Additional Medicare Tax since your wages are below the threshold, but your pension pushes you over the AGI limit. The AGI limits are:
MFJ: $250,000 AGI
MFS: $125,000 AGI
All Others: $200,000 AGI
The tax is on investment income that is earned above these AGI limits. It can be a little hard to explain so, a graph may help.
In the first scenario, the taxpayers (MFJ) have $200,00 in "other" income and $50,000 in investment income. Since their AGI does not exceed $250,000, they are not subject to the NIIT.
In the second scenario, the taxpayers have $230,000 in "other" income and $50,000 in investment income. Since their AGI exceeds $250,000, the $30,000 above that amount is subject to the NIIT.
In the third scenario, the taxpayers have $270,000 in "other" income and $50,000 in investment income. Their AGI exceeds $250,000 but only the $50,000 in investment income is subject to the NIIT
You can control your exposure to this tax. Here are some things you can do:
Contribute to a pre-tax retirement account (401(k), 403(b), TSP) to reduce your AGI and reduce the amount of investment income subject to the tax
Be careful with IRA conversions/distributions. While they don't count as investment income, they do increase AGI and potentially more of your investment income will be subject to the NIIT.
Spread capital gains over time. If you are selling an asset with a large capital gain, look at an installment sale to spread the proceeds over many years to keep your AGI below the threshold.
Our tax code is complicated. As you add more income/assets that complexity only increases. The Additional Medicare Tax and NIIT are just one example.
Military Finances are Different
Most civilians in the workforce don't have a pension like you will as a retired Senior Military Officer or NCO. If you work with a Financial Advisor that isn't well versed in your military benefits, you (and he or she) might get surprised by one or both of these taxes. That's why we think you should work with a financial planner that deals with your unique benefits and circumstances each and every day. Use the button below to schedule a free, initial consultation.
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