The Affordable Care Act, which was passed in 2010, had over 2,200 pages of law. Buried within were the provisions that will add a 3.8% Medicare surtax on qualifying net investment income to your tax bill beginning this year. This surtax applies to taxpayers that exceed certain income thresholds. When it applies, the Medicare surtax adds an extra burden of 3.8% in taxes on unearned income, and it can increase your effective tax rate substantially on that income. This surtax was intended to be one of the ways to fund the costs of the Affordable Care Act, so you do not have to be on Medicare or of Medicare age to incur the tax.
Who is Subject to this Tax?
The Medicare surtax applies to individuals, estates, and certain trusts. For individuals, the tax is equal to 3.8% multiplied by the lesser of Net Investment Income (NII) or Modified Adjusted Gross income (MAGI) in excess of the following thresholds:
- $250,000 for married couples filing jointly,
- $125,000 for married couples filing separately,
- $200,000 for single taxpayers and taxpayers filing as head of household
For estate and trusts, the surtax is equal to 3.8% multiplied by the greater of NII or taxable income in excess of $11,950 (for 2013). MAGI is Adjusted Gross Income (AGI) with some minor adjustments, such as the add back of the foreign earned income exclusion.
What is Net Investment Income?
NII includes taxable interest, dividends, capital gains, rental and royalty income, non-qualified annuities, and business income that is passive to the taxpayer. Note that any taxable "excess" capital gain on the sale of your primary residence (after excluding the $250,000 or $500,000 one-time exclusion) is also considered NII. Further, if you own an interest in a business such as an S corporation, limited liability company or partnership in which you do not materially participate, the income from these businesses is also NII.
NII does not include wages, operating income from a non-passive business, Social Security benefits, IRA and retirement plan distributions, alimony, tax-exempt interest, and self-employment income.
How is the 3.8% Tax Calculated?
Here are a few examples.
Example 1. Adam and Eve Taxpayer have W-2 income of $175,000 and have an additional $75,000 of NII. Their MAGI is $250,000 ($175,000 + $75,000). Since they are not over the MAGI threshold ($250,000), their NII is not subject to the 3.8% surtax.
Example 2. Same facts as Example 1 except Eve receives an additional $60,000 bonus. Now their earned income is $235,000 ($175,000 + $60,000), and their MAGI is $310,000 ($235,000 + $75,000 of NII). MAGI exceeds the threshold by $60,000 ($310,000 – $250,000). The lesser of the excess MAGI ($60,000) or NII ($75,000), so $60,000 in this example, is subject to the 3.8% surtax resulting in additional tax of $2,280.
Example 3. Same facts as Example 1 except Adam also is allocated $100,000 of pass-through business income from an S corporation in which he materially participates (i.e., non-passive). Although this income is not NII, it is taken into account for MAGI purposes. MAGI is now $350,000 ($175,000 wages + $75,000 NII + $100,000 non-passive business income) and exceeds the threshold by $100,000 ($350,000 – $250,000). The lesser of the excess MAGI ($100,000) or NII ($75,000), so $75,000 in this example, is subject to the 3.8% surtax resulting in additional tax of $2,850. Note that even though the non-passive business income is not NII, it still increases the surtax because it increases MAGI.
Example 4. Same facts as Example 3 except NII is zero. Their MAGI is now $275,000 ($175,000 wages + $100,000 non-passive business income) and exceeds the threshold by $25,000 ($275,000 - $250,000). But because the tax is imposed on the lesser of the excess MAGI or NII, and NII in this example is zero, there is no additional surtax.
What Else Should I Know?
Any increase in NII automatically increases MAGI. An increase in earned income or other non-NII income is not directly subject to the 3.8% surtax but can still result in a tax increase, as we saw in Example 3 above. Once your MAGI exceeds the threshold by more than your NII, further increases in non-NII income will not increase the 3.8% surtax.
Minor children who file their own tax returns generally must pay tax on their investment income at their parents' tax rate. The child will not be subject to the 3.8% Medicare tax unless his or her own MAGI exceeds the threshold. If you report your child's NII on your own tax return to avoid having to file a tax return for your child, his or her NII is added to your NII and MAGI for computing the 3.8% surtax.
The Affordable Care Act added another new tax, the additional 0.9% Medicare tax on earned income. This tax is assessed on earned income, such as wages or self-employment income, over certain thresholds. The earned income thresholds that apply to the 0.9% tax are the same as the MAGI thresholds that apply to the 3.8% Medicare tax on unearned income (e.g., $250,000 for married couples filing jointly). And, yes, you can be assessed both the 3.8% Medicare surtax and the 0.9% additional Medicare tax on earned income.
Like your regular income tax, both the 3.8% and 0.9% Medicare taxes are subject to estimated tax penalties if your taxes are not paid timely throughout the year. If you have not accounted for these new taxes in your quarterly estimated payments, you may need to increase your withholding or estimated payments for the balance of the year.
How Can I Avoid or Minimize the Medicare Surtax?
Due to the manner in which the 3.8% Medicare tax is calculated, there are two elements that must be managed – your NII and your overall MAGI. There are numerous ways to lower these factors, but advanced planning is a necessity. Here are just a few suggestions:
Timing Income Recognition. You may be able to time the receipt of income to lower your MAGI, especially in years where you anticipate a large amount of NII, such as when you have a sale generating a large capital gain. Conversely, you may be able to time the recognition of NII to increase it in a year when your overall MAGI is lower, such as when you have a pass-through loss from an operating business. And you should consider closing capital loss positions in years where you have capital gains, but be mindful of the wash sale rules if you are considering reacquiring the same security.
Investing in Non-NII Products. Certain investment income is not included in NII. The cash build up in life insurance policies, for example, is not currently included in your income or considered NII. Likewise, tax exempt interest from municipal bonds is not NII and not included in MAGI.
Converting Passive Income to Non-passive Income. If you own an interest in an S corporation, partnership or LLC and are passive with respect to that activity, increasing your level of activity to where you are deemed to materially participate may change the income to no longer be NII. Note that doing so with a partnership or LLC potentially could trigger self-employment tax issues.
Combining with Other Planning Tools. For taxpayers who are charitably minded, there are some tax efficient tools that also avoid the surtax. A Charitable Remainder Trust (CRT) lets you sell highly appreciated assets without incurring any current income or tax on the sale. You reserve a stream of payments from the CRT for many years for yourself or beneficiaries that you designate. At the end of the trust term, the charity gets the remainder. By using a CRT, you can avoid the tax on a large gain and the 3.8% surtax, get a current income tax deduction, and leave the remainder to charities of your choice.
A good understanding of the unique relationship between NII and MAGI is an important foundational step for clients seeking to minimize the 3.8% Medicare surtax. Many tax rates are going up for 2013. The maximum tax rate for qualified dividends and long term capital gains rates is increasing from 15% to 20%. Add on the 3.8% surtax and the top federal rate for this character of income is 23.8% (an increase of 25.3%). The top individual tax rate on other income is increasing from 35% to 39.6%. Add on the 3.8% surtax and the top federal rate for this income is 43.4% (an increase of 10.9%).
These Medicare taxes are complex and new for 2013. Combining the 3.8% Medicare surtax with the 0.9% additional Medicare tax on earned income (plus the complexities for those that have state income taxes) requires expert knowledge of the new rules. If you believe you may be subject to these new taxes, consult your local CBIZ MHM tax professional.
Copyright © 2013, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. To ensure compliance with requirements imposed by the IRS, we inform you that—unless specifically indicated otherwise—any tax advice in this communication is not written with the intent that it be used, and in fact it cannot be used, to avoid penalties under the Internal Revenue Code, or to promote, market, or recommend to another person any tax related matter. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.
CBIZ MHM is the brand name for CBIZ MHM, LLC and other Financial Services subsidiaries of CBIZ, Inc. (NYSE: CBZ) that provide tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies.