What Is Medicare Tax?
Medicare tax, also known as “hospital insurance tax,” is a federal employment tax that funds a portion of the Medicare insurance program. Like Social Security tax, Medicare tax is withheld from an employee’s paycheck or paid as a self-employment tax.
Medicare tax pays for Part A of the Medicare program, which includes hospital insurance for individuals age 65 or older and people who have certain disabilities or medical conditions. Medicare hospital insurance covers hospital visits, hospice, nursing home care, and some home healthcare.
- Medicare taxes fund hospital, hospice, and nursing home expenses for elderly and disabled individuals.
- In 2021, the Medicare tax rate is 2.9%, which is split between an employee and their employer.
- Self-employed individuals are responsible for both portions of Medicare tax but only on 92.35% of business earnings.
- There are two additional Medicare surtaxes that apply to certain high earners.
How Medicare Tax Works
Just about anyone who works in the U.S. is required to pay Medicare taxes. Under the Federal Insurance Contributions Act (FICA), employers are required to withhold Medicare tax and Social Security tax from employees’ paychecks. Likewise, the Self-Employed Contributions Act (SECA) mandates that self-employed workers pay Medicare tax and Social Security tax as part of their self-employment tax.
Medicare taxes and Social Security taxes are put into trust funds held by the U.S. Treasury. Medicare tax is kept in the Hospital Insurance Trust Fund and is used to pay for Medicare Part A. Costs of Medicare Part B (medical insurance), and Medicare Part D (prescription drug coverage) are covered by the Supplemental Medical Insurance Trust Fund, which is funded with premiums paid by beneficiaries, tax revenue, and investment earnings.
The money is intended to be used for both current and future Medicare beneficiaries. However, the Hospital Insurance Trust Fund has been facing solvency and budget pressures and is expected to be exhausted by 2026, according to the 2019 Trustees Report. If this happens, then Medicare services may be cut, or lawmakers may find other ways to finance these benefits.
In 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act expanded the Medicare program to cover treatment for individuals affected by the COVID-19 pandemic. This included increased Medicare payments for hospital stays and durable medical equipment related to COVID-19.
2021 Medicare Tax Rates
In 2021, the Medicare tax rate is 2.9%, which is split evenly between employers and employees. W-2 employees pay 1.45%, and their employer covers the remaining 1.45%. Self-employed individuals, as they are considered both an employee and an employer, must pay the full 2.9%. Unlike Social Security tax, there is no income limit to which Medicare tax is applied.
An individual’s Medicare wages are subject to Medicare tax. This generally includes earned income such as wages, tips, vacation allowances, bonuses, commissions, and other taxable benefits up to $200,000 as of 2021.
In 2013, the Affordable Care Act (ACA) introduced two Medicare surtaxes to fund Medicare expansion: the additional Medicare tax and the net investment income tax. Both surtaxes apply to high earners and are specific to different types of income. It is possible for a taxpayer to be subject to both Medicare surtaxes.
Additional Medicare Tax
The additional Medicare tax applies to individuals whose earned income—including wages, compensation, and self-employment income—exceeds certain thresholds. For example, in 2021, single filers who earn more than $200,000 and married couples filing jointly who earn more than $250,000 are subject to an additional Medicare tax.
The 2021 additional Medicare tax rate is 0.9%. However, the additional 0.9% only applies to the income above the taxpayer’s threshold limit. For example, if you earn $225,000 a year, the first $200,000 is subject to Medicare tax of 1.45%, and the remaining $25,000 is subject to additional Medicare tax of 0.9%.
Like the initial Medicare tax, the surtax is withheld from an employee’s paycheck or paid with self-employment taxes. However, there is no employer-paid portion of the additional Medicare tax, meaning the employee is responsible for paying the full 0.9%.
Net Investment Income Tax
The net investment income tax, also known as the “unearned income Medicare contribution surtax,” is an additional 3.8% tax applied to net investment income as of 2021. Like the additional Medicare tax, there is no employer-paid portion.
Net investment income may include taxable interest, dividends, nonqualified annuities, capital gains, and rental income. It does not include income that is already excluded for income tax purposes, such as tax-exempt municipal bond interest. Net investment income tax is applied to an individual’s net investment income or the excess modified adjusted gross income (MAGI) over certain thresholds, whichever is less.
For example, let’s say a married couple filing jointly earned $225,000 in wages. During the same tax year, the couple also received $50,000 in investment income, bringing their MAGI to $275,000. The net investment income tax threshold for married couples filing jointly is $250,000. The couple is required to pay 3.8% tax on the lesser of the excess MAGI ($25,000) or the total amount of investment income ($50,000). In this case, the couple would owe a net investment income tax of $950 (3.8% x $25,000).