Will the 3.8% Medicare Surtax Hit You? Find Out.

This is the third in a four part series on pending tax legislation and how it can affect you.

For tax years beginning January 1, 2013, the tax law imposes a 3.8 percent surtax on certain passive investment income of individuals, trusts and estates. For individuals, the amount subject to the tax is the lesser of (1) net investment income (NII) or (2) the excess of a taxpayer’s modified adjusted gross income (MAGI) over an applicable threshold amount.

Net investment income includes dividends, rents, interest, passive activity income, capital gains, annuities and royalties. Specifically excluded from the definition of net investment income are self-employment income, income from an active trade or business, gain on the sale of an active interest in a partnership or S corporation, IRA or qualified plan distributions and income from charitable remainder trusts. MAGI is generally the amount you report on the last line of page 1, Form 1040. The applicable threshold amounts are shown below:

Married taxpayers filing jointly $250,000
Married taxpayers filing separately $125,000
All other individual taxpayers $200,000

A simple example will illustrate how the tax is calculated.

Example.

  • Al and Barb, married taxpayers filing jointly, have $300,000 of salary income and $100,000 of NII.
  • The amount subject to the surtax is the lesser of (1) NII ($100,000) or (2) the excess of their MAGI ($400,000) over the threshold amount ($400,000 -$250,000 = $150,000).
  • Because NII is the smaller amount, it is the base on which the tax is calculated.
  • Thus, the amount subject to the tax is $100,000 and the surtax payable is $3,800 (.038 x $100,000).

Fortunately, there are a number of effective strategies that can be used to reduce MAGI and or NII and reduce the base on which the surtax is paid. These include :

  1. Roth IRA conversions
  2. Tax exempt bonds
  3. Tax-deferred annuities
  4. Life insurance
  5. Rental real estate
  6. Oil and gas investments
  7. Timing estate and trust distributions
  8. Charitable remainder trusts
  9. Installment sales
  10. Maximizing above-the-line deductions

We would be happy to explain how these strategies might save you large amounts of surtax.

Source: AICPA

On Thursday I will be discussing Accelerating Ordinary Income and Estate Tax Provisions, so be sure to check back.