The new Medicare surtax

Starting Jan. 1, 2013, various provisions from President Obama’s Patient Protection and Affordable Care Act will come into effect. From a tax perspective, one of the more significant provisions is the 3.8 percent Medicare surtax.

This surtax applies to individuals, trusts, and estates that have income that exceeds specific thresholds. However, it is important to note the surtax is assessed differently for trusts and estates than it is for individuals. The income threshold amounts depend on the filing status of the taxpayer and are $250,000 for married filing joint filers, $125,000 for married filing separate filers, and $200,000 for all other filers.

Please note, the tax does not apply to nonresident aliens, trusts of which all unexpired interest are devoted to charitable purposes, trusts that are exempt from tax under Section 501, and charitable remainder trusts that are exempt from tax.

How the surtax is computed
For individuals, the 3.8 percent surtax is imposed on the lesser of:

(1) Net investment income for the tax year or
(2) The amount by which the modified adjusted gross income (MAGI) exceeds the threshold amount in that year

For trusts and estates, the 3.8 percent surtax is imposed on the lesser of:

(1) The undistributed net investment income for the tax year or
(2) The excess of the taxpayer’s adjusted gross income over the dollar amount at which the highest tax bracket begins

Net investment income is defined broadly to include all the following:

• Interest, dividends, royalties, and annuities
• Rents and other passive activity income
• Capital gains from the sale of property (not used in an active trade or business) and 
• Trading of financial instruments and commodities

Net investment income does not include the following: 

• Active trade or business income
• Ordinary and capital gain on the sale of an active interest in a partnership or S-corporation
• Distributions from IRAs or qualified retirement plans 
• Income from tax-exempt municipal bonds
• Tax deferred nonqualified annuities
• Income subject to self-employment tax
• Excludable gain under § 121 (exclusion of gain from sale of principal residence)

MAGI is calculated as follows:

A surtax case study
Following is an example of how the Medicare surtax is calculated for a married filing joint taxpayer:

Planning for the surtax
Though many taxpayers will be subject to the 3.8 percent surtax, several strategies can be employed to reduce the impact. Please keep in mind when considering the implementation of any of these planning techniques, your primary focus should be the economic returns, not tax minimization.

Rebalance portfolios to include municipal bond investments - Income from tax-exempt municipal bonds are not considered net investment income for surtax purposes. However, some bonds are not state tax-exempt and/or are alternative minimum tax (AMT) preference items so take into consideration the income differential for planning purposes.

Convert traditional IRAs to Roth IRAs – Distributions from Roth IRAs are not taken into account when analyzing the income thresholds for individuals nor are the distributions considered net investment income. On the other hand, it is important to factor in the tax that would be due on a Roth IRA conversion when analyzing the benefit of the conversion.

Consider the sale of personal residences before Jan. 1, 2013 – There is a $250,000 or $500,000 exclusion on the gain from the sale of a personal residence for single and married filing joint taxpayers, respectively. The sale of a primary residence could trigger the surtax in one of two ways. First, if the gain on the sale is greater than the exclusion amount, it will increase the taxpayer’s net investment income. Second, any gain from the sale above the exclusion amount will be included in the calculation for MAGI.

Consider installment sales – Installment sales can be used to limit the amount of net investment income recognized in the year of a sale of a business and in subsequent years. Installment sales can only be used in certain sale situations as it depends on the type of assets sold. If a taxpayer was “active" in the business that was sold, the gain would not be considered net investment income; however, it would be factored into the MAGI calculation. If there is an opportunity to sell a business prior to 2013, it may be advantageous as a taxpayer would escape the 3.8 percent surtax and potentially benefit from lower capital gain rates.

Maximize contributions to qualified retirement plans – Contributions to plans may reduce income amounts and help minimize MAGI. Additionally, distributions from these plans are not considered net investment income, but are factored into the MAGI computation. These plans include: employer-sponsored defined benefit plans, ESOPs, 401(k) plans, 403(b) plans, money purchase plans, and 457(b) plans.

Many taxpayers have the potential to be subject to the Medicare surtax, but with careful planning they may be able to mitigate the impact of it.

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