Understanding the Tax
The 3.8% investment income surtax, also known as the health care surtax or "Medicare tax", applies to tax year ending after December 31, 2012. The surtax is:
- For individuals, 3.8% of the lessor of:
- net investment income for such taxable year; or,
- the excess, if any of:
a. the modified adjusted gross income for the year, over
b. the threshold amount.
- For trusts and estates, 3.8% of the lesser of:
- the undistributed net investment income for the year; or,
- the excess, if any of:
a. the adjusted gross income (as defined in Code Section 67 (e) for the year, over
b. the dollar amount at which the highest tax bracket in Section 1(e) begins for the year ($11,200 in 2010).
Three Key Numbers
There are three numbers that determine how this surtax will affect a client:
- Net Investment Income. This is the sum of gross investment income over allocable investment expenses. For purposes of this surtax, investment income includes interest, dividends, capital gains, annuities, rents, royalties and passive income. Investment income does not include active trade and/or business income; any of the income sources listed above (e.g., interest , dividends, capital gains, etc.) to the extent it is derived in an active trade and/or business; distributions from IRA's and other qualified retirement plans; or any income taken into account for self-employment tax purposes. For the sale of active interest in a partnership or S corporation, gain is included as investment income only to the extent net gain would be recognized if all of the partnership/ S corporation interests were at fair market value.
- Modified Adjusted Gross Income ("MAGI"). Here, MAGI is the sum of adjusted gross income (the number from the last line on page 1 of Form 1040) plus the net foreign income exclusion amount.
- Threshold Amount.
- Married taxpayers filing jointly............................$250,000
- Married taxpayers filing separately....................$125,000
- All other individual taxpayers..............................$200,000
- Trusts and Estates......................(Beginning of the top bracket ($11,200 for 2010).
Who will pay the new Surtax?
Here is a quick formula to determine if the the 3.8% surtax will apply:
- MAGI less than or equal to the threshold amount = no tax
- MAGI greater than the threshold amount = Tax is 3.8% of the lesser of investment income; or MAGI threshold amount
Note that the surtax liability is determined on income BEFORE any tax deductions (page 2 of Form 1040) are considered. As a consequence, a client with lots of deductions could be in the lowest tax bracket and yet have investment income that is subject to the surtax! Also, because the capital gains rate has increased to 20% in 2011, with the 3.8% surtax in 2013 the effective capital gains rate will become 23.8%.
Planning Tip: Start adjusting trust and estate investments now to reduce income in 2013 and beyond.
Planning Considerations: For taxpayers who could be hit by the surtax, look for ways to invest income and MAGI:
- The 3.8% surtax does NOT apply to distributions from IRAs and other qualified retirement plans, and contributions to these plans provide tax-deferred growth. Therefore, taxpayers may wish to increase contributions to IRAs, 401(k) plans, 403(b) plans and 457 plans. However, be aware that required minimum distributions for those over 70 and 1/2 will increase MAGI as those distributions are considered ordinary income.
- The 3.8% surtax does not apply to distributions from Roth IRAs. However, Roth conversion income will count toward MAGI. Thus, 2011 and 2012 Roth conversions can help to avoid the surtax by reducing post 2012 MAGI from required minimum and other plan distributions in 2013 and beyond.
- Because income from tax-exempt and tax-deferred vehicles like municipal bonds, tax deferred non-qualified annuities, life insurance and non qualified deferred compensation are not included in investment income, investments in these vehicles should be more favorable.
- Charitable Remainder trusts should be more appealing because they permit taxpayers to defer income over a period of time, enabling them to stay under the threshold amount.
- Charitable lead trusts will become more popular to shift investment income to a CLT which in turn will be offset by the "above the line" charitable deduction.
- Installment sales will be popular to smooth income.
- Oil and gas (with 95% initial investment deduction, 15% depletion allowance and IDC deduction on passive oil and gas) will continue to be attractive investments.
- For eligible estates and electing trusts, select the proper year to reduce the surtax. For example, Frieda dies in January 2012. Her estate elects a November 30, 2012 year end. Result: The surtax will not apply to her estate until the year beginning December 1, 2013, providing 11 additional months without the surtax.
Roth IRA Conversions today reduce future MAGI
As stated earlier, required minimum distributions from a traditional IRA are exempt from the surtax; but, they increase MAGI. This can effectively create a 43.4% effective tax rate on IRA distributions in later years (39.6% income tax plus 3.8% surtax on investment income made surtaxable by the IRA distribution).
Planning Tip: Converting to a Roth prior to 2013 can reduce MAGI in 2013 and beyond and thereby reduce or eliminate surtax exposure.