August 31, 2012

With the Supreme Court’s finding that the 2010 federal healthcare act is constitutional, it’s time to consider one of the revenue-raising provisions of the act and the ways it may affect next year’s tax situation.

As a generalization, the net investment income of taxpayers with total income over a certain threshold is subject to a new Medicare investment tax of 3.8 percent beginning in 2013.

money and stethoscope

As with almost any tax provision, the devil is in the details, and the details start with the definitions. The additional tax applies only to married couples with modified adjusted gross income over $250,000 (over $125,000 for married couples filing separately). Single filers face a threshold of $200,000.

For this purpose, modified adjusted gross income means total income on page 1 of your Form 1040, plus the foreign earned income exclusion. So, unless you have worked outside the United States and qualify for the exclusion, the threshold is based on the amount at the bottom of page 1 of your Form 1040.

This means that all income is included and only certain deductions apply, such as self-employed retirement contributions and health insurance. Items such as charitable contributions reduce your taxable income on page 2 of your 1040, but they do not reduce the exposure to this investment tax.

Net investment income is income from interest, dividends, royalties, annuities and certain other income. Net rents after expenses are included but not for real estate professionals. Flow-through income from trusts, LLCs, partnerships and S corporations is included if the income is considered passive to the recipient. Gains on the sale of investment assets are generally included in net investment income as well.

Investment income does not include income from tax-exempt municipal bonds, distributions from qualified plans or IRAs, or income or distributions from flow-through entities in which the investor materially participates.

The tax also applies to trusts and estates if they have income that has not been distributed and the income is in excess of the highest tax bracket in that year. These tax brackets are quite short. For 2012, trusts and estates are generally at the top tax bracket with only $11,650 of income. Charitable trusts are exempt.

Example 1

John, a single filer, has $175,000 of salary and $75,000 of net investment income. His modified adjusted gross income is $250,000, less the $200,000 single-taxpayer threshold, leaving $50,000 of income in excess of the threshold. The lower of net investment income and excess income is $50,000. At a 3.8 percent tax rate, Medicare investment tax of $1,900 is due, in addition to any other tax.

Example 2

Misty and David are married and have $200,000 of combined salary, $50,000 of interest and dividend income, and $100,000 of net rental income from an investment partnership. Their modified adjusted gross income is $350,000, less the $250,000 threshold for a married couple filing jointly, leaving $100,000 of income in excess of the threshold. The lower of net investment income and excess income is $100,000. Medicare investment tax of $3,800 is due.

This investment tax is actually a third income tax system, separate from the regular federal income tax and the alternative minimum tax (AMT). It can be seen as a separate system because you can owe the investment tax without owing either the regular income tax or the AMT.

For example, you could have significant income yet also have large deductions and credits that eliminate your income tax liability. However, you could still owe this Medicare investment tax.

Consider some planning ideas for this new tax:

  • Shift savings and investment strategy to tax-exempt invest¬ments and tax-deferred retirement assets.
  • If rents are a major source of your net investment income, a cost segregation study might increase your depreciation expense and reduce your net rental income.
  • If you have significant unrealized capital gains in your portfolio, consider selling those assets in 2012 before the new tax takes effect.
  • Consider using a charitable remainder trust, both to shelter a large gain from net investment income and to prevent a large one-year bulge in your total income subject to the MAGI threshold.
  • Plan for your installment-sale strategy. For sales beginning in 2012, you might consider electing out of the installment method, reporting all of the gain in 2012 and avoiding the tax on the gain from installments collected in future years.
  • If you are considering a Roth IRA conversion, converting a traditional IRA to a Roth IRA this year would be wise in planning for the investment tax. If you wait until 2013, although your IRA income is not considered net investment income, the bump in income from the conversion will increase your modified adjusted gross income subject to the threshold.
  • Shift investment assets to children with lower investment income. The so-called “kiddie tax” will remove much or all of the income tax savings, but the investment tax savings may remain.
  • Trusts should reconsider the amount of distributions paid out to avoid paying this tax at the trust level.

Talk with your tax adviser about how the Medicare investment tax will affect your tax situation in 2013. But remember, in the end, this is only an additional 3.8 percent tax. While that amount may be substantial in certain circumstances, the cost of this tax may not offer a sufficient reason to make dramatic changes in your affairs.

Project the expected effect of this tax on your tax picture first, determine how much of it can be avoided with certain changes, and then consider whether the net savings truly justifies the changes.

This article was originally posted on August 31, 2012 and the information may no longer be current. For questions, please contact GRF CPAs & Advisors at