A new 3.8% Medicare tax is imposed on net investment income of certain taxpayers for tax years beginning after 2012. The Medicare tax has historically only applied to earned income. The new tax is part of Pres. Obama's "Patient Protection and Affordable Care Act." The new tax will be assessed as part of the income tax returns of individuals, trusts, and estates. The tax is 3.8% of the lesser of:
1. Net investment income (NII) or
2. The excess of modified adjusted gross income (MAGI) over the following threshold amounts:
a. $250,000 for joint filers
b. $125,000 for married filing separately
c. $200,000 for individual filers
d. $12,000 as estimated for trusts and estates (the start of the top income tax bracket as indexed for inflation)
Before defining the above terminology in detail, several observations are worth noting about the new tax:
1. Only 3% of taxpayers have MAGI over $250,000, so this is really a tax on Pres. Obama's so-called "wealthy."
2. The thresholds are not indexed for inflation, so over time more people will become subject to the tax.
3. The threshold for married persons is not double the amount for single persons. This increases the cost of the so-called marriage penalty.
4. Coupled with the sunset of the Bush-era tax cuts, the top federal tax rate in 2013 will be 43.4% on ordinary investment income and 23.8% on long-term capital gains. By contrast, the top tax rates in 2012 are 35.0% and 15.0% respectively.
5. Trusts and estates can avoid the 3.8% tax by distributing the NII to beneficiaries. The beneficiaries in turn would include the distributed NII in their calculation of the tax. But a distribution for tax purposes might not be in accordance with goals of the trust or estate plan.
6. Charitable remainder trusts are exempt from this tax.
7. MAGI cannot be reduced with itemized deductions or personal exemptions because these deductions are taken after the calculation of MAGI.
8. Investment expenses are typically claimed as itemized deductions which, while reducing NII, don't reduce MAGI.
9. The tax is imposed on the full amount of NII only if MAGI exceeds the threshold amounts by at least the amount of NII.
10. Estimated tax payments may be necessary to avoid an underpayment penalty.
NII equals investment income minus investment expenses. MAGI equals AGI (the figure at the bottom of page 1, Form 1040) plus any foreign earned income and housing cost exclusions.
Investment income includes the following:
1. Dividends and taxable interest income
2. Short- or long-term capital gains (with certain exceptions)
3. Royalties and the taxable portion of annuity payments
4. Passive activity income which includes
a. Rent net income
b. K-1 income from partnerships, limited liability companies, and S corporations in which you do not materially participate. Material participation generally requires working more than 500 hours in the business during the year.
5. Income earned from the investment of business working capital allocable to K-1s.
6. Hedge fund income
7. Gain on the sale of a principal residence above the $250,000 (single) or $500,000 (joint) exclusion amounts
Investment income does NOT include:
1. Wages and self-employment income (already subject to Medicare tax)
2. Tax-exempt municipal bond interest
3. Traditional IRA and qualified retirement plan distributions
4. Roth IRA distributions
5. Qualified annuity Section 403 plan distributions
6. Deferred compensation Section 457 plan distributions
7. Social Security and alimony income
8. Gain on the sale of nonpassive business ownership interests, except to the extent the business holds investment property
9. K-1 business income from partnerships, limited liability companies, and S corporations in which you materially participate
10. The amount of gain excluded on the sale of a principal residence
A couple of examples illustrate how the tax is calculated. My next blog article will discuss tax-reduction planning strategies.
Example 1: Joe is a single individual with MAGI of $240,000, consisting of wages of $190,000 and NII of $50,000. The new 3.8% Medicare tax applies to only $40,000 of his NII because his MAGI only exceeded the threshold by this amount. His total tax increase is $1,520.
Example 2: Joe and his wife earn $200,000 of wages, have K-1 income of $150,000 from an LLC in which they materially participate, and have $60,000 of investment income and $10,000 of investment expenses. Their MAGI equals $410,000 and NII equals $50,000. The new 3.8% Medicare tax applies to all $50,000 of NII and increases their tax by $1,900.
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