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Due to provisions in the Affordable Care Act, beginning on January 1, 2013, the NIIT applies at a rate of 3.8% to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts.  While 3.8% does not seem like a lot, in a two earner family it is very easy to reach the income threshold and have your interest, dividends, rent income, capital gains and certain business income subject to another 3.8% tax in addition to your regular tax.  What tax professional would want to surprise a client with such news?  Surprises in the tax preparation business are rarely welcomed.

MEDICARE TAX AND THE UNEARNED INCOME MEDICARE CONTRIBUTION TAX

Calculating the Unearned Income Medicare Contribution Tax

The unearned income Medicare contribution tax is an additional tax of 3.8%.  This tax is addition to any regular income taxes.  The tax is calculated by multiplying the 3.8% tax rate by the lower of the following two amounts:

• Net investment income for the year; or
• Modified adjusted gross income over a certain threshold amount.

Net investment income for the purposes of calculating the unearned income Medicare contribution tax includes interest, dividends, capital gains, annuities, royalties, rents, and pass-through income from an passive business such as S-corporations and partnerships.

Ways to avoid this Tax:

The following types of income will not subject to this additional Medicare tax:  tax-exempt municipal bond interest, nontaxable veteran’s benefits, capital gains excluded from the sale of a principal residence, and distributions from IRAs, 403(b) plans, 401(k) plant, 457 plans, pensions, profit-sharing plans, stock bonus plans, or qualified annuity plans.

Modified adjusted gross income for the purpose of calculating the additional Medicare tax is a person’s adjusted gross income with the foreign earned income exclusion or foreign housing exclusion added back in.

Modified adjusted gross income thresholds for the additional Medicare tax are:

• $250,000 for married filing joint filers and qualifying widows or widowers;
• $200,000 for single and head of household filers; and
• $125,000 for married filing separately filers.

Sample calculation:  Suppose Sam and Betty are married and file a joint tax return.  They have $260,000 of salary income combined and $50,000 of investment income from dividends, Interest and capital gains.  Their adjusted gross income is $310,000.  They don’t have any foreign income exclusions.

• Step 1:  Calculate their net investment income, or $50,000.
• Step 2:  Calculate their modified adjusted gross income in excess of the threshold amount, or 310,000 minus 250,000 for joint filers = $60,000.
• Step 3:  Take the lower of net investment income or modified adjusted gross income over the threshold, which is $50,000 in this case.
• Step 4:  Multiply 50,000 by 3.8% = $1,900.

Planning Ahead for the Unearned Income Medicare Contribution Tax

The additional Medicare tax took effect January 1, 2013.  Higher-income individuals will want to do some quick math to see how this tax will impact their finances.  Some tax planning suggestions:

• Shift income-producing investments into tax-deferred plans such as IRAs and 401(k) accounts.
• Consider tax-exempt bonds instead of taxable bonds.
• Pair capital gains with capital losses so that net capital gains are as low as possible.
• Defer selling investments with a capital gain to a year when the additional Medicare tax would not apply.
• Give income-producing investments to children or other family members who aren’t subject to the additional Medicare tax.
• Manage your modified adjusted gross income around the thresholds for the Unearned Income Medicare tax
• Consider meeting the material participation test for income generated by an S corporation or partnership.
• Consider meeting the real estate professional test for income generated by rental properties.
• Increase payroll withholding or estimated taxes to cover the additional Medicare tax.

The issues described above regarding the determination of the net investment income surtax illustrate the problems even moderately high-income taxpayers will encounter in complying with the new rules. Clearly, individuals need to begin planning for the new tax by reducing their net investment income.