Medicare Tax

Medicare tax is the federal payroll tax imposed on wages to fund Medicare's hospital insurance program. Internal Revenue Code section 3101(b)(1) charges the employee 1.45 percent of wages and section 3111(b) charges the employer a matching 1.45 percent, a combined 2.9 percent. A self-employed person pays the whole 2.9 percent under section 1401(b)(1), because there is no employer to split it with. The defining feature is what the rate applies to: every dollar of covered earnings, with no annual maximum.

The statute never uses the popular name. Section 3101(b) is headed "Hospital insurance," and the tax funds the Hospital Insurance trust fund that pays Medicare Part A benefits. "Medicare tax" is the name the IRS, the pay stub and Form W-2 use, and it is the name almost everyone searches for, so both are worth knowing. Note also that Medicare tax and Additional Medicare Tax are two separate charges, and that neither is the net investment income tax, which is a different tax on different income.

The absence of a ceiling is the whole point of the term. Social Security tax stops each year once wages reach the Social Security wage base. Medicare tax does not stop. The reason sits in one clause: section 3121(a)(1) caps taxable wages only "in the case of the taxes imposed by sections 3101(a) and 3111(a)," which are the Social Security halves. The hospital insurance tax at 3101(b) and 3111(b) is left out of that cap, so it runs on every dollar.

It has not always been that way. Medicare tax carried its own ceiling, higher than Social Security's, into the early 1990s. The Social Security Administration records the change in a single sentence: "After 1993, there has been no limitation on HI-taxable earnings." The logic behind the difference is that Social Security retirement benefits are calculated from covered earnings, so capping the earnings that count also caps the benefit the tax buys. Medicare Part A pays the same hospital benefit regardless of what a worker earned, so there is no benefit ceiling for a tax ceiling to match.

What counts as wages is a broader question than what feels like salary. Section 3121(a) defines wages as "all remuneration for employment," including the value of non-cash pay, and then carves out a long list of exceptions. Employer contributions to a retirement plan are outside it; an employee's own pre-tax 401(k) deferral is not, which is why a traditional deferral escapes income tax and still pays Medicare tax. Most employer-paid health coverage is excluded. Bonuses, commissions, taxable fringe benefits and the spread on a nonstatutory stock option exercise are all inside it.

The tax stops when earned income stops. Medicare tax is charged on wages and on net earnings from self-employment, and on nothing else. A retiree drawing a pension, taking withdrawals from a traditional IRA, collecting Social Security and receiving dividends pays no Medicare tax on any of it. A retiree who takes consulting work does pay it on that work, at any age, with no exemption for already being enrolled in Medicare.

Two things a paycheck hides. The first is that the employer's 1.45 percent is legally the employer's own tax, imposed by section 3111(b) as an excise tax on having employees, rather than a second withholding from the worker; it appears on no pay stub and no Form W-2. The second is that the employee's own 1.45 percent is not deductible, and section 275(a)(1)(A) says so outright; neither is the employer's half to the employee. A self-employed person is the exception, and a partial one: section 164(f) allows a deduction for half of the self-employment tax, but expressly excludes the 0.9 percent Additional Medicare Tax from it.

An employer computes Medicare tax on each payment of wages, withholds the employee's 1.45 percent, adds its own 1.45 percent, and deposits both with the IRS on the schedule that applies to its payroll size. At year end the wages subject to the tax appear in box 5 of Form W-2 and the amount withheld in box 6. Those two boxes are separate from boxes 3 and 4, which report Social Security wages and withholding and stop at the annual ceiling.

A self-employed person computes the same tax on Schedule SE instead. Net earnings from self-employment are 92.35 percent of net profit, and the Medicare portion of self-employment tax is 2.9 percent of that figure, with no ceiling. Someone with both a job and a business pays wage Medicare tax on the wages and self-employment Medicare tax on the net earnings, with no offset between them, because neither has a cap that the other could use up.

A hypothetical example. Nadia is paid $9,000 for a December pay period, having passed the Social Security wage base back in October. No Social Security tax is withheld from that $9,000. Medicare tax is 1.45 percent of it, which is $130.50, and her employer owes a matching $130.50 out of its own funds, for $261 in total on that one pay period. Had the same $9,000 been paid in January, the Medicare figures would have been identical and the Social Security tax would have been $558. That difference is the ceiling, and only one of the two taxes has one.

Medicare tax is an obligation rather than a product, so the useful framing is what its design does and does not do.

What the design gets right

• Funding Part A from a flat rate on all earnings gives the program a broad, stable base that does not shrink when high earners' pay rises.
• The absence of a ceiling means the tax rises proportionally with earnings rather than falling as a share of income above a cut-off, which is what happens on the Social Security side.
• Because the rate is flat and uncapped, the amount is easy to predict: 1.45 percent of whatever you are paid, every time, with no mid-year change.

What it costs, and where it bites

• It is charged on earnings whether or not the worker will ever draw a Medicare benefit, and there is no refund for someone who never qualifies.
• A worker who is already enrolled in Medicare still pays it on any wages, which surprises people who take part-time work after 65.
• Combined with Social Security tax, the employee side is 7.65 percent of pay before a dollar of income tax, which is more than many households pay in federal income tax.
• The self-employed feel the full 2.9 percent directly, and the deduction for half of self-employment tax reduces income tax rather than the tax itself.