New 3.8% Medicare Tax on “Unearned” Net Investment Income

High-income taxpayers will be hit with two big tax hikes under the recently enacted health overhaul legislation: a tax increase on wages and a new levy on investments.

To help offset the cost of providing health insurance to millions of Americans, the new law imposes an additional 0.9% Medicare tax on wages above $200,000 for individuals and $250,000 for married couples filing jointly. In addition, for higher-income households, the new law adds a 3.8% tax on unearned income, including interest, dividends, capital gains and other investment income.

It is the 3.8% surtax on “Unearned Income” that we write about today.

3.8% Tax on Unearned Income

Starting in 2013, high-income taxpayers will be subject to a new tax based on net investment income—a 3.8% Medicare contribution tax.  The Health Care and Reconciliation Act of 2010, which amends the Patient Protections and Affordable Care Act, outlines the new Medicare tax.  Here’s an overview of what the new tax will mean to you, and some methods to review to lessen the impact of this tax.

What is the Net Investment Income Tax (NIIT)?

Section 1411 of the Internal Revenue Code imposes The Net Investment Income Tax (NIIT). The NIIT is a tax of 3.8% on certain net investment income of individuals, estates and trusts that have income above certain threshold amounts.

Who is subject to the Net Investment Income Tax?

This new tax will only affect taxpayers whose modified adjusted gross income (MAGI) exceeds $250,000 for joint filers and surviving spouses, $200,000 for single taxpayers and heads of household, and $125,000 for married individuals filing separately. Estates and Trusts will be subject to the Net Investment Income Tax if they have undistributed Net Investment Income, and also have adjusted gross income over the dollar amount at which the highest tax bracket for an estate or trust begins for such taxable year (for tax year 2012, this threshold amount is $11,650).

(For individuals, your AGI is the bottom line on Page 1 of your Form 1040. It consists of your gross income minus certain adjustments to income. If you claimed the foreign earned income exclusion, you must add back the excluded income for purposes of the 3.8% tax.)

If your AGI is above the threshold that applies to you ($250,000, $200,000 or 125,000), the 3.8% tax will apply to the lesser of (1) your net investment income for the tax year or (2) the excess of your AGI for the tax year over your threshold amount. This tax will be in addition to the income tax that applies to that same income.

Example 1: Taxpayer, a single filer, has wages of $180,000 and $15,000 of dividends and capital gains. Taxpayer’s modified adjusted gross income is $195,000, which is less than the $200,000 statutory threshold. Taxpayer is not subject to the Net Investment Income Tax.

Example 2: A married couple that has AGI of $270,000 for 2013, of which $100,000 is net investment income. They would pay a Medicare contribution tax on only the $20,000 amount by which their AGI exceeds their threshold amount of $250,000. That is because the $20,000 excess is less than their net investment income of $100,000. Thus, the couple’s Medicare contribution tax would be $760 ($20,000 × 3.8%).

What is net investment income (NII)?

The net investment income that is subject to the 3.8% tax consists of interest, dividends, annuities, royalties, rents, and net gains from property sales. Income from an active trade or business isn’t included in net investment income, nor is wage income.

Passive business income (within the meaning of IRC section 469) is subject to the Medicare contribution tax. Thus, rents from an active trade or business aren’t subject to the tax, but rents from a passive activity are subject to the tax (however, deductible expenses related to rental income will reduce the amount subject to this tax). Income from a business of trading financial instruments or commodities is also included in net investment income.

Income that is exempt from income tax, such as tax-exempt bond interest, is likewise exempt from the 3.8% Medicare contribution tax. Thus, switching some of your taxable investments into tax-exempt bonds can reduce your exposure to the 3.8% tax. Of course, this should be done with regard to your income needs and investment considerations.

Home sales.

Let’s review how the 3.8% tax applies to home sales. If you sell your main home, you may be able to exclude up to $250,000 of gain, or up to $500,000 for joint filers, when figuring your income tax. This excluded gain won’t be subject to the 3.8% Medicare contribution tax.

However, gain that exceeds the limit on the exclusion will be subject to the tax. Gain from the sale of a vacation home or other second residence, which doesn’t qualify for the income tax exclusion, will also be subject to the Medicare contribution tax.

For example, a married couple has AGI of $200,000 for 2013 and in addition sold their main home for a $540,000 gain. The couple qualified for the full $500,000 exclusion of gain on the sale, leaving only $40,000 of taxable gain. As a result, the couple won’t be subject to the 3.8% tax, because their total AGI ($200,000 + $40,000) will fall below the $250,000 threshold.

Using the aforementioned example, if the gain on the home sale was $680,000, of which $180,000 was taxable, the couple would be subject to the 3.8% tax on $130,000 of the gain. That is the amount by which their total AGI of $380,000 ($200,000 + $180,000) exceeds their $250,000 threshold.

Exceptions from Net Investment Income

Distributions from qualified retirement plans, such as pension plans and IRAs, aren’t subject to the Medicare contribution tax. However, those distributions may push your AGI over the threshold that would cause other types of investment income to be subject to the tax.

This makes Roth IRAs more attractive for higher-income individuals, because qualified Roth IRA distributions are neither subject to the Medicare contribution tax nor included in AGI.

The tax also does not apply to the gain related to the sale of an interest in an S Corporation or partnership, to the extent that the gain on assets held by the entity is from an active trade or business.

What investment expenses are deductible in computing NII?

To determine NII, Gross Investment Income (items described above) is reduced by deductions that are properly allocable. Examples of allocable deductions would include investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, and state and local income taxes properly allocable to items included in Net Investment Income.

How the Net Investment Income Tax is Reported and Paid

For individuals, the tax will be reported on, and paid with, the Form 1040. For Estates and Trusts, the tax will be reported on, and paid with, the Form 1041.

The Medicare contribution tax must be included in the calculation of estimated tax that you owe. Thus, if you will be subject to the tax, you may have to make or increase your estimated tax payments to avoid a penalty.

Planning Strategies

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. Strategies may include (1) Roth IRA conversions, (2) tax exempt bonds, (3) tax-deferred annuities, (4) life insurance, (5) meet the “Material Participation” requirements for your S Corp and Partnership holdings, (6) become a “Real Estate Professional” for purposes of holding rental real property (7) oil and gas investments, (8) timing estate and trust distributions, (9) charitable remainder trusts, and (10) installment sales and maximizing above-the-line deductions.

We would be happy to explain how these and other strategies might minimize your exposure to the Internal Revenue Code Section 1411  surtax. 

Please don’t hesitate to contact us at info@templetonco.com or 561-798-9988 to begin discussing options specific to your tax situation. 

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