As the U.S. average age rises, the costs to supply health coverage in the form of Medicare are also rising. To pay for these benefits a surtax, often referred to as the Medicare 3.8% tax, will begin in 2013.
Who will it affect?
- Single taxpayers with modified adjusted gross incomes(MAGI) of $200,000 or more
- Married taxpayers with modified adjusted gross incomes(MAGI) of $250,000 or more
- Married taxpayers filing separately with MAGI in excess of $125,000
- Trusts and estates that file their own returns and have MAGI in excess of $11,650
What will be taxed?
Unearned income which means investment income such as interest, dividends, capital gains, rent and royalties. (Municipal bond interest will not be subject to the 3.8% surtax.)
How does it work?
It will apply to either the amount of MAGI that exceeds the threshold, or the investment income, whichever is less.
- For example:
- If you are married, and your modified adjusted gross income is $270,000, and your investment income makes up $60,000 of that amount, you’ll pay the 3.8% medicare tax only on the amount of investment income that exceeds the $250,000 threshold, so on $20,000.
- If your investment income were only $10,000, and your modified adjusted gross income was $270,000 you would pay the 3.8% medicare tax on $10,000.
Final regulations came out in regards to many nuances of this new tax. For a summary of these see CliftonLarsonAllen's article Good News on 3.8 Percent Net Investment Income Tax.
Are IRA distributions subject to the 3.8% tax?
Technically IRA distributions are not be subject to this new 3.8% surtax, however, IRA distributions may increase your MAGI, which in effect could make some of your other investment income subject to this 3.8% tax.
For example, if you had $230,000 of investment income and a required minimum distribution of $35,000, your MAGI for the year would be $265,000, making $15,000 of your investment income subject to the surtax.
Are ROTH IRA conversions subject to the Medicare surtax?
Technically taxable income that occurs because of a ROTH IRA conversion is not subject to this new 3.8% surtax, however, the income from the ROTH conversion may increase your MAGI, which in effect could make some of your other investment income subject to this 3.8% tax.
For example, if you had $150,000 of investment income and you converted $150,000 to a ROTH IRA, your MAGI for the year would be $300,000, making $50,000 of your investment income subject to the surtax.
Is annuity income subject to this tax?
Income from non-qualified annuities (for example annuities that are not IRAs, 403bs or 401ks) is considered investment income and will be subject to this tax.
How might this tax affect my real estate transactions?
The National Association of Realtors® has an article, New Medicare Tax on "Unearned" Net Investment Income, that provide details on how this 3.8% tax will or will not affect all forms of real estate income such as rental income, vacation homes and the sale of your primary residence.
Planning for the 3.8% Medicare Surtax
Below are a things high income earners can do to potentially shelter income from this tax:
- Municipal bonds will become even more attractive for high taxpayers, as this form of interest income is not subject to the surtax.
- High income tax payers may wish to convert IRAs to ROTH IRAs before to avoid future required minimum distributions that will put them over the MAGI limits.
- Harvesting capital gains before year end 2012 will also be a smart move, as capital gains that occur in future years will be subject to the tax.
See the American Institute of CPAs article Planning for the New 3.8% Medicare Tax on Unearned Income for additional planning ideas.