In 2010, the health care reform package (the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010) created a new 3.8 percent Medicare contribution tax on the investment income of higher-income individuals that goes into effect in 2013. No one had given too much thought about it back then because it seemed so far in the future. With 2013 quickly approaching, it is not too soon to be aware of this new stealth tax and examine methods to possibly lessen the impact of this tax.
The starting point is to understand what net investment income is subject to this $3.8% tax. The term “Net investment income” includes the following:
Items that are not investment income include:
The tax applies to estates and trusts, on the lesser of undistributed net income or the excess of the trust/estate adjusted gross income (AGI) over the threshold amount ($11,200) for the highest tax bracket for trusts and estates, and to investment income they distribute.
Net investment income is gross income or net gain, reduced by deductions that are “properly allocable” to the income or gain. This is a key term that the Treasury Department expects to address with detailed guidance in the future. We will update our clients as developments and pronouncements become available.
For passively-managed real property, allocable expenses will still include depreciation and operating expenses. Indirect expenses such as tax preparation fees may also qualify.
For capital gain property, this formula puts a premium on keeping tabs on amounts that increase your property’s basis.
Certain investment expenses that may reduce net gains include the following:
As such, taxpayers may want to consider avoiding installment sales with net capital gains (and interest) running past 2012.
Thresholds Of Net Investment Income
The tax applies to the lesser of:
MAGI is your AGI increased by any foreign earned income otherwise excluded under Code Sec. 911; MAGI is the same as AGI for someone who does not work overseas.
Example 2. Joe, a single taxpayer, has modified AGI of $230,000 and net investment income of $40,000. The tax applies to the lesser of (i) net investment income ($40,000) or (ii) modified AGI ($230,000) over the threshold amount for an individual ($200,000), or $30,000. The tax is 3.8 percent of $30,000, or $1,140.
In this case, the tax is not applied to the entire $40,000 of investment income.
Example 3. John and Jane, married and filing jointly, has modified AGI of $310,000 and net investment income of $40,000. The tax applies to the lesser of (i) net investment income ($40,000) or (ii) modified AGI ($310,000) over the threshold amount for an individual ($250,000), or $60,000. The tax is 3.8 percent of $40,000, or $1,520.
In this case, the tax is in fact applied on the entire $40,000 of investment income.
Exceptions to the Tax
Certain items and taxpayers are not subject to the 3.8 percent Medicare tax.
Retirement Plan Exceptions: The following are distributions that are not subject to this tax:
Special Note For Deferred Compensation Plans: There is no exception for distributions from nonqualified deferred compensation plans subject to Code Sec. 409A. Be aware, that distributions from these plans (including amounts deemed as interest) are generally treated as compensation, not as investment income.
Planning Point: The exception for distributions from retirement plans suggests that potentially taxable investors may want to shift wages and investments to retirement plans such as 401(k) plans, 403(b) annuities, and IRAs, or to 409A deferred compensation plans. Increasing contributions will reduce income and may help you stay below the applicable thresholds. Small business owners may want to set up retirement plans, especially 401(k) plans, if they have not yet established a plan, and should consider increasing their contributions to existing plans.
Trade or Business Exception: Another exception is provided for income ordinarily derived from a trade or business that is not a passive activity under Code Sec. 469, such as a sole proprietorship.
Investment income from an active trade or business is also excluded.
Sale of An Business Ownership Interest: The additional 3.8 percent Medicare tax does not apply to income from the sale of an interest in a partnership or S corporation, to the extent that gain of the entity’s property would be from an active trade or business.
Other Exceptions: The tax also does not apply to:
Other Tax Rate Changes To Worry About and That Compound the Problem
In addition to the tax on investment income, the following are certain other tax increases may take effect in 2013.
The possible impact here is that the cumulative rate on capital gains would increase to 23.8 percent in 2013, and the rate on dividends would jump to as much as 43.4 percent. Moreover, the thresholds are not indexed for inflation, so more taxpayers may be affected as time elapses.
Please contact our office if you would like to discuss the tax consequences to your investments of the new 3.8 percent Medicare tax on investment income.
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