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Planning Now for the Future 3.8% Medicare Tax on Investment Income
June 14, 2010
The recently enacted health reform legislation includes a 3.8% Medicare contribution tax on net investment income of higher income taxpayers. While the tax doesn’t kick in for a few years, it’s not too early to start planning on how to minimize its impact. To that end, this article explains how this tax will work and steps that can be taken to reduce or eliminate it.
Medicare tax on investment income.
For tax years beginning after Dec. 31, 2012, a 3.8% tax will apply to net investment income of higher income taxpayers. The tax for individuals is 3.8% of the lesser of (1) net investment income or (2) the excess of modified adjusted gross income (MAGI) over the threshold amount.
Threshold amount.
The threshold amount is $250,000 for a joint return or surviving spouse, $125,000 for a married individual filing a separate return, and $200,000 in any other case.
MAGI.
MAGI is AGI increased by the amount excluded from income as foreign earned income under (net of the deductions and exclusions disallowed with respect to the foreign earned income. Only individuals with MAGI above the applicable threshold amount will be subject to the tax. An individual will pay the 3.8% tax on the full amount of his net investment income if his MAGI exceeds his threshold amount by at least the amount of the net investment income.
Application to estates and trusts.
For an estate or trust, the tax is 3.8% of the lesser of: (1) undistributed net investment income or (2) the excess of AGI over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins.
Exceptions and special rules.
The tax does not apply to a nonresident alien or to a trust all the unexpired interests in which are devoted to charitable purposes, a trust that is exempt from tax under, or a charitable remainder trust exempt from tax under Code Sec. 664. The tax is subject to the individual estimated tax provisions and is not deductible in computing any tax imposed by subtitle A of the Code (relating to income taxes).
Net investment income. For purposes of the Medicare contribution tax, “net investment income” means the excess, if any, of:
- The sum of:
gross income from interest, dividends, annuities, royalties, and rents, unless those items are derived in the ordinary course of a trade or business to which the Medicare contribution tax doesn’t apply (see below),
other gross income derived from a trade or business to which the Medicare contribution tax applies (below),
net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the Medicare contribution tax doesn’t apply, over
- The allowable deductions that are properly allocable to that gross income or net gain. Thus, the 3.8% tax doesn’t reach tax-exempt bond interest and gain from the sale of a principal residence that is excluded under Code Sec. 121. However, to the extent that gain from a sale of a principal residence doesn’t qualify for the Code Sec. 121 exclusion (e.g., the gain exceeds the $250,000/$500,000 limit on the exclusion), it would be subject to the 3.8% tax. Gain from the sale of a vacation home or other secondary residence also would be subject to the tax.
A taxpayer expecting to realize a gain on a principal residence substantially in excess of the applicable $250,000/$500,000 limit who is planning to sell in a few years should try to complete the sale before 2013 when the 3.8% tax first applies.
Doing so rather than selling after 2012 will remove the portion of the gain that doesn’t qualify for the Code Sec. 121 exclusion from the reach of the 3.8% tax. For example, a married couple with an $800,000 gain could save $11,400 ($300,000 × .038). Likewise, completing a planned sale of a highly appreciated second home before 2013 could also save the 3.8% tax that could be triggered if the sale took place after 2012.
Placing a greater portion of one’s investment funds into tax-exempt bonds after 2012 may help to reduce the taxpayers’ exposure to the 3.8% tax. Of course, this should be done with due regard to income needs and investment considerations.
It should be borne in mind that the 3.8% tax is in addition to any regular tax or capital gains tax that may be imposed on the investment income item. Because higher income taxpayers may face increased regular taxes and capital gains taxes in the next few years, reducing the 3.8% tax takes on increased importance.
Trades and businesses to which tax applies.
The Medicare contribution tax applies to a trade or business if it is a passive activity of the taxpayer, or a trade or business of trading in financial instruments or commodities. For a taxpayer that does engage in a passive activity or a financial instrument or commodities trading business, “net investment income” will include the above items, plus the gross income (minus allocable deductions) from the passive activity or trading business. The tax doesn’t apply to other trades or businesses conducted by a sole proprietor, partnership, or S corporation. But income, gain, or loss on working capital isn’t treated as derived from a trade or business and thus is subject to the tax.
Exception for certain active interests in partnerships and S corporations.
Gain from a disposition of an interest in a partnership or S corporation is taken into account as net investment income only to the extent of the net gain that the transferor would take into account if the partnership or S corporation had sold all its property for fair market value immediately before the disposition.
A similar rule applies to a loss from a disposition of an interest in a partnership or S corporation. Thus, only net gain or loss attributable to property held by the entity that isn’t property attributable to an active trade or business is taken into account.
Retirement plan distributions.
Investment income doesn’t include distributions from tax-favored retirement plans, such as qualified employer plans and IRAs. While distributions from qualifying tax favored retirement plans are not investment income for purposes of the 3.8% tax, depending on the type of vehicle and the taxpayer’s basis in it, they could be included in MAGI and thus help to push the taxpayer over the threshold thus causing other types of investment income to be subject to the tax. This may be a reason not to defer a taxpayer’s first required minimum distribution (RMD) from a qualified plan or IRA to Apr. 1 of the succeeding year if the succeeding year is after 2012 when the 3.8% tax applies.
An individual who has the means but is not contributing the maximum permissible amount to 401(k) plan or IRA should do so rather than invest the difference in a regular investment account. Not only will the individual get the income tax advantages of the qualified plan or IRA for the additional contributed amounts but, in the future, he or she may save some 3.8% tax that could have been triggered had the funds been invested in a regular investment account.
The 3.8% Medicare tax makes Roth IRAs look like a more attractive alternative for higher income individuals. Qualified distributions from Roth IRAs are tax-free and thus won’t be included in MAGI, or be subject to theMedicare tax, whereas distributions from regular IRAs (except to the extent of after-tax contributions) will be included in MAGI - but won’t be subject to the Medicare tax.
Taxpayers thinking of rolling over regular IRAs to Roth IRAs should do so before 2013 to avoid winding up with higher MAGI as a result of the rollover. And for IRA-to-Roth-IRA conversions occurring in 2010, unless a taxpayer elects otherwise, none of the gross income from the conversion is included in income this year; half of the income resulting from the conversion will be includible in gross income in 2011 and the other half in 2012.
Amounts subject to SECA taxes.
Investment income does not include amounts subject to SECA taxes.
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