By: Robert Brant, CPA and Kenneth J. Burstiner, CPA | In March 2010, the Patient Protection and Affordable Care Act was signed into law. Its provisions included the establishment of a 0.9% Additional Medicare Tax (code Sec. 3101(b)(2)) and a 3.8% Medicare tax on Net Investment Income (Code Sec. 1411). The additional Medicare tax of 0.9% is imposed on earned income in excess of $200,000 for individuals and $250,000 for married couples filing jointly. For certain taxpayers, the combined Medicare tax rate will approach 2.35%. Employers are required to withhold this 0.9% tax when an employee’s wages meet the criteria; however, they are not required to determine if the threshold is met due to other sources of earned income.
Jane Smith earns $175,000 at ABC Inc. Jane Smith does not meet the threshold, so there is no additional withholding requirement. However, Jane’s spouse also earns $175,000. Together, they meet the threshold for married taxpayers filing jointly, and are responsible for paying the 0.9% tax directly.
John Doe earns $210,000 at XYZ Corp, meeting the threshold for mandatory withholding. If John is married and his spouse has self-employment income of $30,000, their combined earned income does not meet the threshold. Any “excess” tax paid in would be claimed as a credit on their 2013 tax return.
3.8% Medicare Tax on Net Investment Income
For the first time, a payroll-type tax will be levied on investment income. Previously, the Medicare tax has only been levied on wages or self-employment income. The tax is calculated by applying the 3.8% statutory rate to the lessor of (1) net investment income or (2) the excess of Modified Adjusted Growth Income (MAGI) over a threshold amount of $200,000 for single filers and $250,000 for married taxpayers filing jointly. This tax also applies to estates and trusts. If the taxpayer’s MAGI is less than the threshold amounts, no tax is due. The threshold amounts are not indexed for inflation and will likely affect more taxpayers in subsequent years.
Bill is single, with net investment income of $10,000 and MAGI of $205,000. His additional Medicare tax is $190 ($205,000 minus $200,000 X 3.8%). Bill’s MAGI of $5,000 above the threshold is less than his net investment income of $10,000, therefore, the tax is calculated on the $5,000.
Bill has MAGI $175,000 and net investment income of $10,000. Since his MAGI is less than the $200,000 threshold, no tax is due.
Net Investment Income
There are three categories of income:
- i) Gross income from interest, dividends, royalties and rents, unless such income is derived in the ordinary course of an active trade or business other than a securities or commodities business.
- ii) Other types of gross income derived from a) a trade or business that is a passive activity for the taxpayer under Sec. 469, or (b) a financial instrument or commodities business as defined under Sec. 475.
- iii) Net gain attributable to the disposition of property other than property held in an active business that is not a securities or commodities business.
Net investment income does not include Social Security, pensions, IRAs, or tax exempt interest.
What to do? Planning Considerations
There are two variables to consider when planning for this tax – net investment income and MAGI. Reducing one or both will reduce or eliminate the additional tax.
Strategies to consider include:
1. Converting taxable interest to non-taxable interest by purchasing municipal bonds. The interest from these bonds is not subject to the tax nor is it included in the calculation of MAGI.
2. Maximizing contributions to retirement plans.
3. Harvesting capital losses if there are realized gains already in one’s portfolio. Net capital gains will be included in investment income subject to the tax as well as MAGI. Using capital losses will reduce both numbers.
4. Consider increasing participation in “passive activities.” Net investment income includes amounts generated by passive activities such as real estate or rentals. If one increases participation to “materially participate” in an activity, the income will not count as net investment income.
These strategies should be considered in conjunction with an overall investment plan and should be discussed with your tax and investment advisors.
Robert Brant, CPA is the Senior Manager at WeiserMazars LLP and Kenneth J. Burstiner, CPA is the Senior Manager at WeiserMazars LLP