Watch out for the 3.8% Medicare surtax, new this year

In 2010, as part of the health care legislation often referred to as 'Obamacare', Congress passed a new tax provision, the Unearned Income Medicare Contribution. This is a 3.8% surtax, which became effective January 1, 2013, for investment income for individuals, trusts, and estates.

It is referred to variously as the "3.8% surtax," the "3.8% investment tax", and the "3.8% Medicare tax". The 3.8% surtax is found in Section 1411 of the Internal Revenue Code. The IRS issued proposed regulations in December 2012 intended to "help" taxpayers understand the new tax. The "help" is over 100 pages long. The IRS hopes to have final regulations in place by the end of 2013. In the meantime taxpayers can refer to the proposed regulations.

For individuals, the calculation of the 3.8% Medicare Surtax is dependent on two numbers defined as follows: 1) the taxpayer's net investment income (NII) and 2) the taxpayer's modified adjusted gross income (MAGI). For each taxable year, the MAGI, after being reduced by a fixed threshold, is compared to the NII. The 3.8% Medicare Surtax is applied on the lessor of the two. This means that for individuals who have little or no net investment income, their 3.8% Medicare Surtax will be minimal if not zero. The three thresholds mentioned above are:

  • $250,000 for married couples filing jointly
  • $125,000 for married couples filing separately
  • $200,000 for everyone else

Here is an example. Mary Smith, who is single, made $150,000 in salary for 2013. In addition, Mary Smith earned $75,000 of net investment income. Mary's modified adjusted gross income would be the sum of her salary and net investment income, which is $225,000. Her threshold is $200,000. MAGI after being reduced by a fixed threshold is $25,000 ($225,000 - $200,000) When compared to her $75,000 of NII, the 3.8% Medicare Surtax is applied to the $25,000 because it is the lesser of the two numbers. On Mary's 2013 form 1040 she will owe additional taxes of $25,000 x 3.8% or $950. For Mary, the effect of the new surtax is $950 in additional tax.

Estates and trusts get hit harder. The calculation of the 3.8% Medicare Surtax is also dependent on two numbers: an estate or trust's undistributed net investment income ('UNII') and the estate or trust's adjusted gross income (AGI). Similar to the calculation for individuals, the AGI for the taxable year is first reduced by a fixed threshold amount and then compared to UNII. The lessor of the two is multiplied by 3.8% to determine the 3.8% Medicare Surtax for that taxable year. However, the threshold is adjusted each year based on the dollar amount that starts the highest tax bracket. For the fiscal year of 2013, that amount is only $11,950. Compare this to $250,000 for married couple filing jointly.

In order to determine if the surtax applies, it is important to understand what qualifies as net investment income. Net investment income includes the following items, reduced by any deductions allocable to such income:

  • Interest, dividends, royalties, annuities, rents
  • Income derived from passive activities
  • Income from trading financial instruments and commodities
  • Net capital gains derived from the disposition of property (other than property held in an active trade or business)

Net investment income does not include the following:

  • Active trade or business income
  • Gain on sale of an active interest in a partnership or S corporation
  • Distributions from IRAs or qualified retirement plans
  • Income from tax-exempt municipal bonds
  • Tax deferred non-qualified annuities
  • Income taken into account for self-employment tax purposes
  • Capital gain excluded on the disposition of a personal residence

Retirees could be surprised to find that they are victims of the surtax. Although income received from a pension, traditional IRA or company-sponsored retirement plan is not subject to the surtax itself, it can push your other income above the threshold, exposing it to the surtax.

Planning strategies to avoid or reduce the 3.8% surtax are aimed at managing the income threshold limits, as well as the amount of net investment income incurred by the taxpayer. Making deductible contributions ($5,000 max, $6,000 max for those over age 50) to an IRA will lower one's MAGI. Traditional IRA owners are required to take minimum distributions upon reaching age 70 ½. While such distributions are not considered net investment income, they will count toward the surtax's income thresholds.

Income from municipal bonds is not considered net investment income, nor is it considered for purposes of the surtax's income thresholds. It may make sense to consider rebalancing an investment portfolio to increase its municipal bonds.

Family Limited Partnerships (FLP) can serve as vehicles to shelter a portion of an individual's net investment income. Parents can employ the FLP structure to gift partnership interests to younger generations so as to reduce their own net investment income that may be subject to the surtax, as well as distribute such interests to a group of individuals who may be below the MAGI thresholds. The planning strategy can also help the parents reduce the size of their gross estate for estate tax purposes.