A new 3.8% surtax on certain investment income starts January 1, 2013, as part of the health care reform legislation. It applies to net investment income of higher-income individuals. The 3.8% surtax is in addition to your regular income tax, and it is also in addition to any alternative minimum tax.
"Net investment income" includes interest, dividends, annuities, royalties and rents and other gross income attributable to a passive activity. Gains from the sale of property not used in an active business and income from the investment of working capital are also treated as investment income. Further, an individual's capital gains income will be subject to the tax. This includes gain from the sale of a principal residence (unless the gain is excluded from income under Code Sec. 121) and gains from the sale of a vacation home.
The surtax tax will not apply to nontaxable income, such as tax-exempt interest or veterans' benefits.
In general, there are three types of net investment income: 1) income from interest, dividends, annuities, royalties and rents; 2) income from a passive activity, such as income from closely-held family businesses operating in LLC or S corporation form, where some family members own shares but are not actively involved in the business; 3) Net gain "to the extent taken into account in computing taxable income." This includes capital gain. The term "net gain" implies that capital losses incurred in the current year would be taken into account to determine the net gain. It is not clear is whether capital losses that are carried forward from previous years for regular income tax purposes would be allowed for purposes of calculating "net gain" subject to the 3.8% surtax.
The new 3.8% surtax applies to the lesser of net investment income or modified AGI ("MAGI") above $200,000 for individuals and heads of household, $250,000 for joint filers and surviving spouses, and $125,000 for married persons filing separately. MAGI is 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.
The surtax is computed on MAGI before any itemized deductions are considered. Therefore, an individual with lots of deductions could be in the lowest income tax bracket and yet have investment income that is subject to the surtax!
Trusts and estates are affected as well. The surtax is applied to 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.
Here are some examples of income that is not subject to the surtax: wages, salary and other compensation income, income on the exercise of compensatory stock options, and qualified retirement plan distributions. All of these types of income, while exempt from the surtax, are still included in MAGI; so they can still affect your exposure to this surtax.
A significant exception is that the 3.8% surtax does not apply to distributions from qualified plans, 401(k) plans, tax-sheltered annuities, individual retirement accounts (IRAs), and eligible 457 plans.
The surtax 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 is from an active trade or business. The surtax also does not apply to business entities (such as corporations and limited liability companies), nonresident aliens (NRAs), charitable trusts that are tax-exempt, and certain charitable remainder trusts.
Individuals who expect to be subject to the surtax may want to increase contributions 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. They should consider increasing their contributions to existing plans.
The maximum long-term capital gain rate in 2012 is 15%. It is currently scheduled to increase to 20% in 2013. The 3.8% surtax would make the 2013 maximum rate imposed on capital gain 23.8%. In some cases it could make sense to accelerate gain into 2012 in order to incur the lower rate.
Since the income from a passive activity will be subject to the 3.8% surtax, consider increasing your level of activity so that the business income becomes nonpassive in order to avoid the surtax.
Investing in tax-exempt bonds should be considered since their interest is not subject tot he surtax or the regular income tax. Compare the after-tax yields of both taxable and tax-exempt bonds.
Consider converting your traditional IRA to a Roth IRA. This is a good idea even without the consideration of the surtax. Distributions from a Roth are exempted from the surtax and the income tax. The Roth conversion, when done, will cause the recognition of income. While it's not subject to the surtax per se, it will drive up MAGI which could affect your exposure to the 3.8% surtax in the year of conversion. This is another great reason to convert to a Roth before 2013.