By now you have most likely heard of the new “3.8% tax” also known as the “net investment income tax”, “unearned income Medicare contribution tax” or “Medicare surtax”. No matter what it is called, it is important to understand the specifics of this new tax.
The Medicare surtax applies to income earned from January 1, 2013 and will therefore not impact your 2012 tax return.
Does the New Surtax Apply to you?
The Medicare surtax applies to individuals, estates, and certain trusts. For individuals, it applies to joint filers or those filing as surviving spouse with a modified adjusted gross income (MAGI) over $250,000, single filers or those filing as head of household with a MAGI over $200,000, and married filing separate filers with a MAGI over $125,000.
Considerations for Calculating Net Investment Income (NII)
The Medicare surtax applies to net investment income (NII). Examples of NII are interest, dividends, capital gains, rents, royalties, non-qualified annuities, income from businesses involved with the trading of financial instruments and commodities, and passive income (net of profits and losses). Please note that NII also includes gain from the sale of your personal residence that is in excess of $250,000 for a single taxpayer or $500,000 for married filing joint taxpayers. In addition, the interest, dividends, and capital gains of your children may be included in your NII calculation if they are subject to the kiddie tax.
Income that is not considered NII includes wages, unemployment compensation, operating income from a non-passive business, social security benefits, alimony, tax exempt interest, self employment income, and distributions from certain qualified plans (such as distributions from an IRA account).
The income subject to the surtax may be offset by certain allocable expenses such as investment interest expense, investment advisory fees, brokerage fees, expenses related to rental and royalty income, and state and local taxes.
The tax is calculated on the lesser of 1) the net investment income (NII) or 2) the excess of modified adjusted gross income (MAGI) over the thresholds listed above. The tax rate is 3.8% of the lower amount.
Here are a few examples of how the Medicare surtax is calculated:
Example #1. Taxpayers, married filing joint, have wages of $210,000 with $15,000 of dividends and capital gains. Taxpayers’ modified adjusted gross income is $225,000, which is less than the $250,000 threshold. Taxpayers are not subject to the Medicare surtax.
Example #2. Taxpayers, married filing joint, have wages of $210,000 with $55,000 of dividends and capital gains. Taxpayers’ modified adjusted gross income is $265,000. The taxpayers’ have exceeded the threshold by $15,000 and have net investment income of $55,000. The Medicare surtax would be based on the lesser of the two, and would be $570 ($15,000 x 3.8%).
Example #3. Taxpayers, married filing joint, have wages of $300,000 with $55,000 of dividends and capital gains. Taxpayers’ modified adjusted gross income is $355,000. The taxpayers’ have exceeded the threshold by $105,000 and have net investment income of $55,000. The Medicare surtax would be based on the lesser of the two, and would be is $2,090 ($55,000 x 3.8%).
Take Advantage of Planning Opportunities
There are some planning opportunities to help reduce the impact of the Medicare surtax. One opportunity is to review your investment portfolio for the allocation between taxable and tax-exempt bonds. Interest on corporate bonds is considered NII and could be subject to the Medicare surtax. Interest on tax-exempt bonds are not considered NII and would not be subject to the Medicare surtax. Of course, the after-tax return on any investment must be taken into consideration to determine the best decision for your overall portfolio. Another planning opportunity would be using installment sales to help allocate investment income between different years and possibly avoid the Medicare surtax depending upon the total NII for each year.
The new Medicare surtax can become quite complicated. Since the Medicare surtax should be factored into your quarterly estimated tax payments for 2013, it is important to understand the new tax and the planning opportunities associated with it. Your service team at DGC can help you navigate this new surtax. Please contact us to set up a meeting to discuss how the Medicare surtax will impact you.