In the wake of the U.S. Supreme Court decision upholding the constitutionality of the health-care law supported by President Obama—officially the “Patient Protection and Affordable Care Act of 2010”—two new Medicare surtaxes went into effect in 2013.
Although these “add-on” taxes could affect your tax liability for years to come, few people seem to be paying much attention to their imminent arrival—and could miss out on the chance to minimize their impact. Here’s a quick review of the basic rules:
The standard tax law definition of “earned income” is used here. That means the 0.9% surtax applies to wages and other forms of employer-based compensation, such as commissions, but not to “unearned” income, such as capital gains and dividends.
For instance, suppose you have annual wages of $350,000 and file a joint tax return with your spouse. You also receive $50,000 in investment income this year. You’ll have to pay the 0.9% Medicare surtax on the $100,000 in wages that exceed the $250,000 threshold. So the extra tax will come to only $900 (0.9% of $100,000). The $50,000 of investment income isn't subject to this surtax.
The health-care law defines “net investment income” to include interest, dividends, royalties, rents, gains from dispositions of property, and income from passive activities. But it doesn’t cover tax-exempt interest or distributions from traditional and Roth IRAs and qualified retirement plans such as 401(k) plans, 403(b) plans, and pension plans. Yet while IRA and qualified retirement distributions are excluded from the definition of net investment income, receiving such distributions likely will increase your MAGI for the year, possibly triggering or increasing the amount of the surtax.
Also keep in mind that because of the way it’s structured, the 3.8% Medicare surtax could apply to someone who has relatively little in the way of investment income. Consider the following examples.
Example 1: A single taxpayer has $210,000 of MAGI consisting of $195,000 of wages and only $15,000 of net investment income. Nevertheless, he still must pay the 3.8% Medicare surtax because his MAGI exceeds the $200,000 threshold for single filers by $10,000. The tax comes to $380 (3.8% of $10,000).
Example 2: A married couple has $325,000 of MAGI consisting of $275,000 of wages and $50,000 of net investment income from capital gains and dividends. In this case, the 3.8% Medicare surtax applies to the $50,000 of net investment income, since that’s less than the $75,000 by which their income exceeds the MAGI threshold of $250,000. Thus, the couple pays a surtax of $1,900 (3.8% of $50,000).
The 3.8% surtax can be particularly burdensome for an individual who has both high wages and significant investment income.
Example 3: A single taxpayer has $550,000 of MAGI consisting of $350,000 in wages and $200,000 in investment income. The lower amount is the net investment amount, resulting in a surtax of $7,600 (3.8% of $200,000).
Note that the 3.8% surtax also applies to trusts and estates based on a threshold using the dollar amount for the top tax bracket for those entities. For 2017, the threshold is only $12,500. For example, if the net investment income of a trust is $112,500, the trust must pay the 3.8% surtax on the $100,000 excess, for an extra tax liability of $3,800 (3.8% of $100,000). And trusts and estates may already pay a hefty income tax on investment earnings, due to the compressed tax brackets.
What can you do to limit the damage? We may see a renaissance of financial planning strategies based on existing tax-minimizing strategies such as life insurance, tax-deferred annuities, and municipal bonds. But these techniques require a thorough analysis of your finances. They may be appropriate in some situations, but they’re not for everyone.
Do you have a little more fear now about the new Medicare surtaxes? The reach of the law may be greater than you think. Schedule a meeting before year-end to develop a plan.