If you generate retirement income from an investment portfolio, you will not pay FICA taxes such as Social Security and Medicare tax. However, you might owe a supplemental Medicare tax if you are a high earner. If you generate retirement income from working a job, running a business or otherwise earning income, you will pay the same FICA taxes on that money as you did pre-retirement. Here’s what you need to know. However, you can simplify the process by working with a professional, such as a financial advisor who specializes in tax situations.
What Are FICA Taxes?
The FICA tax, short for Federal Insurance Contributions Act tax, is a federal payroll tax levied on all forms of earned income. It is what’s known as a regressive flat tax, meaning that it applies the same fixed rate to all taxpayers and is structured such that high earners pay a lower effective rate the more they earn.
Unlike federal income tax, which goes into general revenues, FICA taxes are specifically earmarked for certain programs. Specifically, this tax pays for Social Security and Medicare.
You only pay FICA taxes on what’s called “earned income.” While the definition can get complex, broadly speaking earned income is defined as any money that you received in exchange for work or effort. For most people, this tax applies to W-2 paychecks, 1099 contractor income, business income and other self-employment income. The self-employed pay double and for them this is categorized as the “self-employment tax.”
You Do Not Pay FICA Taxes On Investment Income
For retirees, the nature of the FICA tax matters because of what it omits. As a payroll tax, FICA does not apply to investment income. You do not pay Medicare and Social Security taxes on the money your portfolio generates. That includes capital gains, interest payments and dividends.
Much of the reason for this is that you have already paid FICA taxes on this money. When you contribute to a pre-tax retirement account, such as a 401(k), the IRS still charges FICA taxes on that money. You only get to deduct those contributions from your federal income tax. If you contribute to a post-tax account, such as a Roth account or an ordinary portfolio, then you have again already paid FICA taxes on those contributions.
So, for most people, the answer is no. If you are a retiree who lives on the proceeds of their investments, you will not pay Medicare taxes in retirement.
The Net Investment Income Tax
But every rule has an exception, and the Net Investment Income Tax is the exception here.
In 2013 Congress passed a supplemental tax to help boost revenue for the Medicare program. This is known as the Net Investment Income Tax. It is a 3.8% tax that applies only to investment income in households with a high enough total adjusted income for the year. At the time of writing, this tax applied to all households with a modified adjusted gross income above $200,000/$250,000 single/joint.
This tax only applies to the portion of your MAGI generated by investments and only to earnings above the threshold. So, for example, say that you are a married couple with $275,000 in portfolio earnings. You would pay the Net Investment Income Tax on $25,000 (the amount of earnings above the cap).
You Do Pay FICA Taxes On Earned Income
Finally, retirement does not change the taxable status of earned income. If you do any work in retirement, for example, if you pick up a part-time job or continue to run a business, that income will be subject to FICA taxes as usual. Increasingly relevant, this will apply to any freelance or contractor-based income. So, for example, if you drive for Uber or rent a room on Airbnb, these will be considered earnings.
Bottom Line
Medicare taxes are part of FICA taxes, a flat-rate payroll tax levied on all earned income. This tax does not apply to investment income, so your retirement portfolio will not be subject to FICA taxes but it may be subject to the alternative Net Investment Income Tax if your income is high enough.
Medicare Tips
- A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- So you aren’t paying Medicare taxes in retirement, probably. What are the ins and outs of getting coverage under this program?
Photo credit: ©iStock.com/Aum racha, ©iStock.com/PeopleImages, ©iStock.com/BakiBG