Prepared for the New Surtax?

As part of Obama Care, we have a new tax beginning in 2013. The official name of this tax is the “Unearned Income Medicare Contribution Tax,” and even though the name implies it is a contribution, don’t get the idea you deduct it as a charitable contribution. It is, in actuality, a surtax levied on the net investment income of higher-income taxpayers.

The surtax is 3.8% on the lesser of your net investment income or the excess of your modified adjusted gross income (MAGI) over a threshold based on your filing status. MAGI is your regular AGI increased by income excluded for working out of the country; net investment income is your investment income reduced by investment expenses.

The filing status threshold amounts are:

• $250,000 for married taxpayers filing jointly and surviving spouses.
• $125,000 for married taxpayers filing separately.
• $200,000 for single and head of household filers.

Example - A single taxpayer has net investment income of $100,000 and MAGI of $220,000. The taxpayer would pay a Medicare contribution tax only on the $20,000 amount by which his MAGI exceeds his threshold amount of $200,000, because that is less than his net investment income of $100,000. Thus, the taxpayer's Medicare contribution tax would be $760 ($20,000 × 3.8%).

Investment income includes:

• Interest, dividends, annuities (but not distributions from IRAs or qualified retirement plans), and royalties,
• Rents (other than derived from a trade or business),
• Capital gains (other than derived from a trade or business),
• Home sale gain in excess of the allowable home gain exclusion,
• Your child’s investment income in excess of the excludable threshold if, when eligible, you elect to include your child’s investment income on your return,
• Trade or business income that is a Sec. 469 passive activity with respect to the taxpayer, and
• Trade or business income with respect to trading financial instruments or commodities.

Planning Note: for surtax purposes, gross income doesn't include interest on tax-exempt bonds. Thus, one can avoid the net investment income surtax by investing in tax-exempt bonds.

Investment expenses include:

• Investment interest expense,
• Investment advisory and brokerage fees,
• Expenses related to rental and royalty income, and
• State and local income taxes properly allocatable to items included in Net Investment Income.

Do you think you will never get hit with this tax because your income is way under the threshold amounts? Don’t be so sure. When you sell your home, the gain is a capital gain, and to the extent that the gain is not excludable using the home gain exclusion, it will add to your income, and possibly push you above the taxation thresholds. And, since capital gains are investment income, you might be in for a surprise. The same holds true for gains from selling stock and a second home. So when planning to sell a capital asset, be sure to consider the impact of this new surtax.

The surtax also applies to undistributed net investment income of trusts and estates, and there are special rules applying to the sale of partnership and Sub-S Corporation interests.

If this surtax will apply to you in 2013, you may need to increase your income tax withholding or estimated tax payments to cover the additional tax so you can avoid or minimize an underpayment of estimated tax penalty when you file your 2013 return.

If you have questions about this new tax or wish to do some related tax planning, please give our office a call.