Planning Ideas for New 3.8% Medicare Tax on Investment Income

As previously posted, there is a new 3.8% Medicare Surtax On Investment Income starting in 2013.

Since the inception of the Medicare program, the Medicare tax has only been imposed on an employee’s wages and a self-employed individual’s earned income. Starting in 2013, a new 3.8% Medicare Surtax will be imposed on all or a portion of the net investment income (e.g., interest, dividends, annuities, royalties, rents, and capital gains) of certain higher-income individuals. The tax will apply to married individuals filing jointly with modified adjusted gross income (MAGI) exceeding $250,000 (exceeding $200,000 if single, $125,000 if married filing separately). Trusts and estates that have net investment income in excess of certain threshold amounts will also be required to pay the 3.8% Medicare Surtax, unless the income is timely distributed to beneficiaries. However, if the income is timely distributed, the beneficiaries of the trust or estate may be subject to the Medicare Surtax.

What Is Included In Net Investment Income? Generally, net investment income includes (net of allocated deductions) interest, dividends, annuities, royalties, rents, gain from the sale of property (e.g., capital gains), and operating income from a business that trades in financial instruments or commodities. It also includes operating income from any other business which is a passive activity (unless the operating income constitutes self-employment income subject to the 2.9% Medicare tax on earned income). For this purpose, a passive activity is any business activity (other than an activity conducted through a C corporation) which is subject to the passive loss limitation rules because the owner does not materially participate in the business. For example, you are deemed to materially participate in a business and, therefore, the business is not passive if you spend more than 500 hours during the year working in the business.

Is Any Investment Income Exempt From The Surtax? Yes. For purposes of the 3.8% Medicare Surtax on investment income, investment income does not include: tax-exempt bond interest; gain on the sale of a principal residence otherwise excluded from income under the home-sale exclusion provisions; or distributions from qualified plans, IRAs, 403(b) annuities, etc.

Planning Alert! Taxable distributions from qualified plans, traditional IRAs, etc., will increase your MAGI which could, in turn, push you over the $250,000 (joint return) or $200,000 (single return) thresholds, subjecting your net investment income to the 3.8% Medicare Surtax.



The following are a few observations and planning considerations relating to the new 3.8% Medicare Surtax on investment income:

  • Consider Roth IRA Conversions.

Since tax-free distributions from a Roth IRA do not increase your MAGI and thus will not increase your exposure to the Medicare Surtax, this should be factored into any analysis of whether you should convert your existing IRA to a Roth IRA. However, if the conversion occurs after 2012, the income triggered by the conversion increases your MAGI and therefore your potential exposure to the Medicare Surtax. Thus, by converting to a Roth prior to 2013, you may avoid any Medicare Surtax that would otherwise apply because of the conversion.

Planning Alert! Whether you should convert your traditional IRA to a Roth IRA can be an exceedingly complicated issue, and this new Medicare Surtax makes the decision even more complex.

  • Tax-Exempt Income Becomes More Valuable.

Investing in products that produce tax-exempt income will gain more importance. For example, tax exempt municipal bond interest will potentially provide higher income taxpayers with a double tax benefit: 1) the interest will not be included in the taxpayer’s MAGI thus reducing the chance that the taxpayer will exceed the income thresholds for the 3.8% Medicare Surtax, and 2) the tax-exempt interest itself is exempt from the Medicare Surtax.

  • Additional Benefits For Contributions To Qualified Retirement Plans.

By maximizing your deductible contributions to qualified retirement plans (e.g., traditional IRAs, 401(k)s, SEPs, etc.), you will potentially receive a double tax benefit: 1) your contributions will reduce your MAGI and reduce your chance of exceeding the income thresholds that would expose your current net investment income to the Medicare Surtax, and 2) the retirement plan distributions that you receive when you retire will be exempt from the Surtax.

  • Recognizing Gains On Investments Held More Than One Year In 2012.

With the scheduled increase in the maximum long-term capital gains rates from 15% to 20% in 2012, and the imposition of the new 3.8% Medicare Surtax on capital gains starting in 2013, timing your sales of stocks, bonds, or other securities has become much more complicated. High-income taxpayers may save taxes by selling their appreciated long-term capital investments that have peaked in value in 2012, instead of waiting until 2013 or later. Likewise, overall tax savings may occur if these taxpayers postpone selling investments producing capital losses until 2013 or later, so that those losses can shelter capital gains that otherwise would be subject to the higher 20% capital gains rate and the 3.8% Medicare Surtax.

Caution! Always consider the economics of a sale or exchange first!

If you have any questions about the new Medicare Tax on Investment Income or planning ideas, please do not hesitate to contact us.

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