New 3.8% Medicare Contribution Tax on Unearned Income

Beginning in 2013

The 2010 Health Care Act, as amended by the 2010 Health Care Reconciliation Act, imposes a Medicare contribution tax on unearned income (Medicare contribution tax) on individuals, estates, and trusts. The tax is generally levied on income from interest, dividends, annuities, royalties, rents, and capital gains, but can also be levied on home sale gains in excess of the applicable exclusion amount.

For individuals, the tax is 3.8% of the lesser of;  

(a) net investment income  

or   

(b) the excess of modified adjusted gross income (MAGI) over the applicable threshold amount.   

The threshold amount for those subject to the tax is $250,000 for joint returns or surviving spouses, $125,000 for separate returns, and $200,000 in other cases.  

Net investment income is investment income reduced by the deductions properly allocable to such income.  

Fortunately, qualified retirement plan distributions are not included in investment income.  

MAGI is adjusted gross income (AGI) increased by the amount excluded from income as foreign earned income, net of the deductions and exclusions disallowed with respect to the foreign earned income.   

What are the planning opportunities?

If 2013 MAGI is under the applicable threshold amount, there will be no Medicare contribution tax liability.

Idea #1 - Move ordinary income from 2013 to 2012. Where possible, taxpayers can reduce their 2013 MAGI by receiving 2012 bonus, profit sharing, or other incentive payments in 2012 versus 2013. But recognize that doing so will accelerate into 2012 the regular income tax due on these payments.   

Idea #2 - If possible sell capital assets in 2012 and realize the capital gains in 2012 rather than 2013.  If the 15% capital gains tax rate is allowed to expire at 12/31/2012 and revert to the 20% rate, realizing the capital gain in 2012 will have a secondary benefit, in addition to avoiding the new 3.8% tax on investment income 

Example #1: 

Single taxpayer's MAGI exceeds the $200,000 threshold.  

Carol, a single taxpayer, has net investment income of $100,000 and MAGI of $220,000 in 2013. She would pay a Medicare contribution tax on $20,000, the amount by which her MAGI exceeds the $200,000 threshold since this is less than her net investment income of $100,000. Carol's 2013 Medicare contribution tax would be $760 ($20,000 × 3.8%).

However, if a taxpayer's 2013 MAGI exceeds the threshold amount by at least the amount of the net investment income, the taxpayer will pay 3.8% on the full amount of his or her net investment income.

Example #2:    

Taxpayer's MAGI exceeds the threshold by more than net investment income.

Wesley, a single taxpayer, has 2013 net investment income of $110,000 and MAGI of $400,000. Because his MAGI exceeds the $200,000 threshold amount by more than his net investment income, he would pay a Medicare contribution tax on his full $110,000 net investment income. Wesley's 2013 Medicare contribution tax would be $4,180 ($110,000 × 3.8%).

A large home sale gain could be subjected to the Medicare contribution tax. However, any amount realized from the sale of a principal residence excluded from federal taxation (up to $250,000; $500,000 for certain married couples filing a joint return) is not subject to the Medicare contribution tax.