Overview
Starting in 2013, if your Adjusted Gross Income (AGI) is over $200,000 as a single taxpayer or $250,000 as a married taxpayer filing jointly, the following new Medicare taxes may impact your 2013 tax liability:
- 0.9% on wages and self-employment income
- 3.8% on the lesser of your “net investment income” or your AGI over the threshold amounts listed above ($200K or $250K)
Note: you could be subject to both taxes, however, the increases do not apply to the same category of income. You will never pay the additional 0.9% and the 3.8% on the same income.
Further Information on 3.8% tax on Net Investment Income
Net Investment Income for the purposes of the 3.8% tax includes taxable interest and dividends, long and short term capital gains, annuity income, royalties, passive rental income and income from a passive trade or business. Items excluded from net investment income include wages, self-employment income, distributions from retirement plans/IRAs, S Corps/LLC profits (assuming active participation) and tax exempt interest/dividends.
Note: distributions from retirement accounts are not considered investment income; however, they are included in the calculation of your AGI to determine if you are above the AGI threshold.
Application to Trusts
The 3.8% tax also applies to estates and trusts. The tax is computed on the lesser of undistributed net investment income or the excess amount of AGI over the threshold amount ($11,650 for 2012).
Individual Taxpayer 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 AGI 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 have to pay an additional $1,900 (($250,000 – $200,000) X 3.8%).
Example 3 — Fred and Sue have $195,000 of capital gain and dividend income. Their AGI for 2013 totals $262,500 and they file a joint return. Their AGI is $12,500 over the threshold for married taxpayers ($262,500 – $250,000). They will pay the 3.8% tax on the $12,500 excess AGI because it is less than their $195,000 of net investment income. Their additional tax for 2013 is $475 (($262,500 – $250,000) X 3.8%).
Example 4 — Mike and Denise, married filing jointly, also have net investment income of $195,000, but their 2013 AGI totals $526,000. Their additional tax is calculated on the lesser of net investment income, $195,000, or their excess AGI over the threshold, $276,000 ($526,000-$250,000). Thus, their tax base is $195,000 and their liability for the tax is $7,410 ($195,000 X 3.8%).
Example 5 — Karen and Howard, married taxpayers, have wages of $225,000 and net investment income of $90,000 making up their 2013 AGI of $315,000. The couple will incur the additional 3.8% tax on the lesser of their $90,000 of net investment income, or $65,000 of AGI in excess of the $250,000 threshold. Thus, Karen and Howard will incur a $2,470 (3.8% x $65,000) unearned income Medicare contribution tax in 2013.
Example 6 — Diana and Mark, married taxpayers, have wages totaling $275,000 and net investment income of $0 in 2013. For 2013, the couple will incur an additional 3.8% tax on the lesser of their $0 of net investment income or $25,000 of AGI in excess of the $250,000 threshold. Because Diana and Mark have no unearned income they would not have an unearned income Medicare contribution tax in 2013. However, their excess wages would be subject to the additional 0.9% tax on wages and earned income.
Example 7 — A married couple, filing jointly, have $130,000 of 401(k) income and $110,000 of net investment income. One spouse took a $50,000 distribution from a Roth IRA. The couple has AGI of $240,000. The 3.8 percent surtax 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 income purposes, nor is the distribution deemed net investment income.
Example 8 — A married couple, filing jointly, have $130,000 of 401(k) income and $110,000 of net investment income. One spouse took a $50,000 distribution from a Traditional IRA. The couple has AGI of $290,000. The 3.8 percent surtax applies to $40,000 of net investment income, the lesser of the net investment income of $110,000 or the amount over the $250,000 threshold. Note: Traditional IRA distributions are not classified as net investment income; however, they are considered for AGI purposes.
Example 9 — In 2013, a married couple sells their principal residence. The sale qualifies for up to $500,000 of the gain to be excluded from their income under Code Sec 121. The total gain on the sale of the residence is $700,000. The taxpayers’ net investment income is $200,000 ($700,000 gain − $500,000 exclusion on sale of primary residence). They have no other net investment income in 2013. Their AGI is computed by adding the $200,000 of gain not excluded from the sale of their residence to their salary of $310,000; thus, their 2013 AGI is $510,000. Their AGI is $260,000 above the threshold for married filing joint taxpayers ($510,000 − $250,000). The tax applies to the lesser of their $200,000 net investment income or the excess of their AGI over the threshold, $260,000. Therefore, they will pay a 3.8% unearned income Medicare tax of $7,600 (.038 x $200,000) as a result of selling their residence at a $700,000 gain.
Trust Examples
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 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.
Planning Opportunities
For 2012, your situation may benefit from taking advantage of the current year’s lower rates. Below, please find some areas that can be considered for year-end as we plan for these tax increases:
- Assess your current realized and unrealized gains and losses to avoid additional tax and potentially harbor losses for 2013;
- Consider tax exempt bonds which are excluded from AGI calculations;
- Convert to a Roth IRA in 2012 to avoid future inclusion of taxable distributions included in AGI;
- Review trust provisions and planning considerations (for example, distributing to beneficiaries instead of keeping investment income in trust).
Please contact us if you have any questions.