The New 3.8% Medicare Tax on Investment Income

January 1 of this year, Obamacareʼs (Patient Protection and Affordable Care Act) 3.8 percent Medicare Tax on the unearned income of “high income” individuals above certain thresholds went into effect. The purpose of this newly created tax is to help pay for the nationʼs healthcare costs. The tax is imposed on passive and unearned income such as capital gains, dividends, interest, annuities, royalties, rents, and all income from passive activity on individuals earning $200,000 or above and joint filers earnings $250,000 and above ($125,000 for married taxpayers filing separate returns). A couple is subject to this surtax starting at $250,000 of income whereas if they were single they would each have a $200,000 threshold or a total of $400,000 before this new tax would kick in. This is a whopping 60 percent increase in the threshold of two single taxpayers over a married couple. This new tax stretches widely over most types of portfolio income.

The new Internal Revenue Code Section 1411 defines and applies the 3.8 percent tax on unearned income for high-income individuals (listed above); in addition to a new 0.9 percent Medicare tax on earned income. The combination of these two new taxes is estimated to raise $317.7 billion over the next 10 years.

The surtax on individuals equals 3.8 percent of the lesser of 1) net investment income or 2) the excess if any of the individualʼs adjusted gross income (AGI) for the tax year over the threshold income levels listed above. One of our clients, a married couple, has salaries of $225,000 and about $90,000 of investment income and rental income. The extra 3.8 percent tax in 2013 is approximately $2,500. We are suggesting moving a portion of their investments into tax-free municipal bonds versus taxable bonds, in addition to raising their 401-K contributions so they can minimize this surtax.

Types of Income Excluded

Recently the IRS and Treasury issued proposed regulations which precisely define what is subject to the 3.8 percent tax. It does not include Social Security income, tax-exempt interest, retirement income, alimony, or any item taken into account in determining selfemployment income for the tax year. Also excluded are distributions from pensions, profit-sharing plans, a 403(b) tax-sheltered annuity, any other kind of qualified annuity (held inside a retirement account), IRAs, Roth IRAs and 457(b) plans. However, be aware that the distribution from retirement plans might push oneʼs AGI over the threshold to make the investment income subject to the surtax. Also, it excludes income from a trade or business in which the taxpayer actively wor ks in. S corporation distributions escape both the 3.8 percent Medicare tax and the 0.9 percent Medicare tax on earned income as long as the taxpayer is an active participant in the business (if ownership is passive, all partnership, LLC or S corporation income would be classified as passive investment income and subject to the surtax). For example, a client who owns and operates nursing homes in a Florida S corporation but does not materially participate in the business will be subject to the Medicare surtax. Gain on a sale of a partnership, LLC or S Corporation interest in which there was a material participation by the taxpayer at the time of sale is not subject to the surtax.

Gains that are not recognized for income tax purposes in a particular year are not subject to the surtax, including: (1) installment sales (2) tax-free exchanges; (3) involuntary conversions; and (4) excludable gain ($250,000/$500,000) on the sale of principal residence.

One concern receiving a lot of attention lately has been the application of the 3.8 percent surtax on gains from the sale of a residence. Any capital gain that is otherwise subject to income tax on the sale of a principal residence would also be subject to the surtax. Investing in life insurance is definitely an easy way to avoid the tax. All growth in a life policy is tax deferred if designed properly. Income withdrawn is not taxable as long as it does not exceed your investment. Any withdrawals beyond your investment can be taken out in the form of loans which are non-taxable. In addition, borrowing from a life insurance policy can help prevent being subjected to any income or Medicare surtax.

Proper Planning is Key

Net capital gains from investment accounts are perhaps the most common type of income subject to the surtax. In that regard, it is important to note that short-term or long-term gains are subject to the same 3.8 percent surtax, irrespective of the ordinary income rate applied to short term gains or the lower rate applied to long-term capital gain. Year end capital gain harvesting has never been more important given the recent increase in the capital gain rate plus this Medicare surtax. Basically, anyone in these income levels should consider planning opportunities very carefully in order to minimize the impact of this new tax along with all the other recent changes in income taxes that have gone into effect.

For more information, please contact Bradford Hall, CPA at 949.910.4255 or bh@hallcpas.com.