Beginning in 2013, there are three primary tax changes that will impact “high income” taxpayers:
1. An Additional Medicare Tax of 0.9% on wages and self-employment income in excess of $200,000 as a single taxpayer or $250,000 as a married taxpayer filing jointly ($125,000 married filing separately)
2. A new 3.8% Medicare Surtax on unearned income. The surtax is a 3.8% tax on the lesser of your “Net Investment Income” or your Modified Adjusted Gross Income (MAGI) income in excess of $200,000 as a single taxpayer, $250,000 as a married taxpayer filing jointly ($125,000 married filing separately).
Note: while you may be subject to both taxes, the ‘Additional Medicare Tax of 0.9%’ and the ‘3.8% tax on Net Investment Income’ do not apply to the same categories of income.
3. New 39.6% tax bracket and 20% long-term capital gain rate for those having taxable income as follows:
- single – over $400K
- married filing joint – over $450K
- head of household – over $425K
- married filing separate – over $225K
Note: These taxes could be in addition to the Medicare tax driving new effective top rates of 43.4% and 23.8% (LTCG).
Additional Medicare Tax on Wages
Taxpayers will be subject to a .9% tax on wages and self-employment income in excess of threshold amounts of over $200,000 as a single taxpayer or $250,000 as married taxpayer filing jointly ($125,000 married filing separately). Each taxpayer with wages in excess of $200,000 will have the additional .9% Medicare tax withheld from his or her wages. The final determination of whether the taxpayer(s) are subject to the tax is made in their tax return. Married taxpayers filing jointly will aggregate their Medicare wages for purposes of the tax. Excess amounts withheld from a taxpayer’s wages for the additional Medicare tax can be applied against regular tax liability.
Additional Medicare Tax – Examples
Example 1: Jeff has wages of $220,000 and files as a single taxpayer. Jeff is subject to the additional Medicare tax of .9% of the excess wages over the $200,000 threshold for taxpayers filing single returns. The additional Medicare tax is $180 (($220,000 – $200,000) x .9%). Jeff’s employer should have withheld this amount from Jeff’s wages.
Example 2: Howard has wages of $100,000 and Jane has wages of $180,000. Howard and Jane file a joint return. Because neither Howard’s nor Jane’s wages exceeded $200,000, additional Medicare tax was not withheld from their individual wages. However, on their return, their wages total $280,000, surpassing the threshold of $250,000. The excess wages of $30,000 result in an additional Medicare tax of $270 (($280,000 – $250,000) x .9%).
3.8% Tax on Net Investment Income
‘Net Investment Income’ includes taxable interest and dividends, long and short term capital gains, capital gain distribution, annuity income, royalties, passive rental income and income from a passive trade or business (generally received on Form K-1 from a pass-through entity). Items excluded from net investment income include wages, self-employment income, distributions from retirement plans/IRAs, income passed through from S Corporations/LLC (assuming active participation by the taxpayer), and tax exempt interest/dividends.
Note: distributions from retirement accounts are not considered investment income. However, they are included in the calculation of your MAGI to determine if you exceed the MAGI threshold.
Application to Trusts
The 3.8% tax on net investment income also applies to estates and trusts. The tax is computed on the lesser of undistributed net investment income or the excess amount of MAGI over the threshold amount ($11,650 for 2013).
Net Investment Income Tax Examples
Example 1: Jay, a single taxpayer, has $125,000 of salary and $50,000 of net investment income. The new Medicare tax will not apply to him because his MAGI is under the $200,000 threshold.
Example 2: Maria, a single taxpayer, has $250,000 of net investment income and no other income. She would be subject to an additional tax $1,900 (($250,000 – $200,000) X 3.8%).
Example 3: Fred and Sue have $195,000 of capital gain and dividend income. Their MAGI for 2013 totals $262,500 and they file a joint return. They will pay $475 (($262,500 – $250,000) X 3.8%) on the $12,500 in excess of their MAGI due to it being less than their $195,000 of net investment income.
Example 4: Mike and Denise, married filing jointly, have net investment income of $195,000, and their 2013 MAGI totals $526,000. The additional tax is calculated on the lesser of net investment income, $195,000, or their excess MAGI over the threshold amount, $276,000 ($526,000-$250,000). The tax on net investment income is $7,410 ($195,000 X 3.8%).
Example 5: A married couple, filing jointly, have $130,000 of 401(k) distributions and $110,000 of net investment income. One spouse also took a $50,000 distribution from a Roth IRA. The couple’s MAGI is $240,000. The 3.8% percent tax on net investment income does not apply because the couple’s MAGI is below the $250,000 threshold.
Note: qualifying Roth IRA distributions are not taken into account for determining MAGI, nor are distributions included in net investment income.
These are relatively simplistic examples. Taxpayers are also entitled to deduct certain expenses against the ‘Tax or net Investment Income”, (e.g., investment interest, state taxes, tax prep fees, rent/royalty expenses, etc.). This is a separate taxing system that requires additional calculation.
Example 6: A married couple, filing jointly, have $130,000 of 401(k) distributions and $110,000 of net investment income. One spouse also took a $50,000 distribution from a traditional IRA. The couple has MAGI of $290,000. The 3.8% percent tax on net investment income applies to $40,000, the lesser of the net investment income of $110,000 or the amount in excess of MAGI over the $250,000 threshold. Note: IRA distributions are taken into account for determining MAGI, but are not included in investment income.
Example 1: A trust has investment income of $60,000 and has not made any distributions during the tax year. The 3.8 percent surtax applies to $48,350 ($60,000 – $11650) of income, the lesser of the net investment income of $60,000 or the amount over the $11,650 threshold.
Example 2: A trust has investment income of $60,000 and during the tax year has distributed 100 percent of the income. The 3.8 percent surtax will not apply to the trust since it did not retain any investment income. However, depending upon the beneficiary’s situation the surtax may apply at the individual level.
For 2014, your situation may allow you to take advantage of various planning opportunities to limit your exposure to these new taxes.
We would be happy to review with you any questions you may have regarding the new taxes and any future planning opportunities available.
Newburg & Company, LLP