Medicare Surtax Planning

The end of 2013 is in sight. Most of us want to concentrate on holiday plans, travel and family. Tax planning is far down on the list.

Yet 2013 brings new tax regulations, and some year-end planning can alleviate future tax pain – which is an excellent holiday present to yourself.

Beginning with the 2013 tax year, a new Medicare surtax will apply to taxpayers who have net investment income (NII) and whose modified adjusted gross income (MAGI) exceeds a certain threshold. This new surtax will essentially raise the marginal income tax rate for affected taxpayers and is entirely separate from the regular income tax and alternative minimum tax. While it is called a “Medicare” surtax, the new tax actually goes toward the general revenue fund of the United States, not specifically to Medicare. The tax is often referred to as the net investment income tax (NIIT).

For individuals, trusts and estates, the surtax is a flat 3.8 percent tax imposed on the lesser of either net investment income or the excess of modified adjusted gross income for the taxable year over the threshold amount. If MAGI does not exceed the threshold amount, the net investment income will not be subject to the new tax.

The IRS defines net investment income as the sum of three “buckets” of gross income, reduced by allowable deductions. The first bucket is gross income from interest, dividends, annuities, royalties and rents (other than those derived in the ordinary course of business or those that are earned passively). Passive activity income, as defined by the IRS, makes up the second bucket. The third bucket comprises net capital gains derived from the disposition of property. Note that net investment income specifically excludes:

  • Income from an active trade or business
  • IRA or qualified plan distributions
  • Income from self-employment
  • Gain from the sale of an active interest in a partnership or S corporation
  • Any amounts exempt from income under income tax law (such as tax-exempt bonds or veteran benefits)

Certain expenses can be taken as deductions to reduce your investment income; thus the term net investment income. Deductions include investment interest expenses, margin expenses, investment counsel and advisory fees, state income taxes allocable to your NII, attorney or accounting fees, and depreciation or amortization deductions. To be deductible, these expenses need to be related to the production of your investment income. The expenses are subject to the same limitations applied to itemized deductions as reported on your Schedule A (such as the 2 percent floor for certain miscellaneous itemized deductions and the overall limitation on itemized deductions for high-income taxpayers, also known as the Pease limitation).

The three different “buckets” of gross income are an important concept in understanding the NIIT. For example, capital losses work slightly differently under the surtax regulations than they do for regular income tax. This is because the net capital gain calculated for net investment income purposes (part of the third bucket of NII) may not be less than zero. Therefore, capital losses may only offset capital gains, not other forms of investment income such as interest or dividends. Nor may you use the up to $3,000 of excess capital losses that are generally allowed to offset other ordinary income for regular income tax purposes.

For example, assume a taxpayer’s only two sources of income were $300,000 of interest and a net capital loss of $250,000. For regular income tax purposes, you are allowed to use $3,000 of the net loss to offset other income, resulting in gross income of $297,000. The remaining capital loss of $247,000 is carried forward to future tax years. However, for purposes of calculating your NII, the capital loss (part of bucket three) may not offset any of the interest income (bucket one). This means, in our example, the taxpayer’s total NII will be the full $300,000 of interest. An easy rule to remember is that investment income may only be offset by losses from other investments within the same bucket.

Modified adjusted gross income, for purposes of calculating the NIIT, is defined as a taxpayer’s adjusted gross income modified by adding the net foreign earned income exclusion. For many taxpayers, this will be the same as their adjusted gross income.

The threshold amount for the surtax depends on your filing status. The amounts are as follows:

  • Single, head of household (with qualifying person), or qualifying widow(er) with a dependent child: $200,000
  • Married filing jointly: $250,000
  • Married filing separately: $125,000
  • Estates and trusts: based on the top tax bracket for the taxable year ($11,950 in 2013)

The threshold amount is the key factor in determining the “lesser of” formula for the purposes of calculating the surtax. Also note that this surtax is charged in addition to the regular federal income tax (and alternative minimum tax), effectively raising the marginal income tax rate for affected taxpayers.

All of this may seem overwhelming. The following examples will help you see how calculating the surtax works in practice.

Example 1: Charlie, a single taxpayer, has $100,000 of salary and $50,000 of net investment income. His MAGI totals $150,000. Because his MAGI is less than the $200,000 threshold, the surtax will not apply.

Example 2: Abigail is also a single taxpayer. She has $225,000 of net investment income, and no other income sources. Since she has passed the MAGI threshold, she owes the 3.8 percent surtax on the lesser of her net investment income or the amount by which her MAGI exceeds the threshold. In this case, she will owe the tax on $25,000, the difference between MAGI and the threshold, as it is less than the entirety of her net investment income.

Example 3: Randy, a single taxpayer, is 69 years old. His net investment income is $200,000, so he is not subject to the surtax. However, next year he will have the same investment income and an additional required minimum distribution from his IRA, totaling $125,000. This pushes his MAGI up to $325,000, though the IRA distribution does not affect his total net investment income. Since Randy’s MAGI exceeds the threshold, he will have to pay the surtax. In this case, he will owe tax on the amount the MAGI exceeds the threshold, $125,000, which is less than his total net investment income ($200,000).