Many investors already know about the 3.8% Medicare surtax lurking in the near future. Depending on your situation, you may have to pay an extra tax on some or all of your investment income, on top of the regular federal and state income taxes you owe. If you’re in the top tax bracket—currently 39.6%—you could end up paying tax at an effective top rate of 43.4%!
The calculation for the surtax involves a two-part process you must go through when you file your tax return. The 3.8% Medicare tax applies to the lesser of (1) “net investment income” and (2) the amount by which your modified adjusted gross income (MAGI) exceeds an annual threshold amount. The surtax is imposed on trusts and estates as well as on individual taxpayers.
With valuable tax dollars at stake, it’s important to understand all the rules. Here’s a quick overview of three key terms:
1. Net investment income. This is probably the most significant definition for investors. For purposes of the 3.8% Medicare surtax, “net investment income” includes income from the following:
Interest and dividends,
Taxable distributions from nonqualified annuities,
Rent and royalties,
Gains from investments in passive activities,
Trades of financial instruments and commodities,
Net capital gain from the sale of property (other than property held in an active trade or business).
Net investment income as defined for the surtax specifically does not include these items:
Salary or wages,
Distributions from IRAs (both traditional and Roth) and qualified retirement plans,
Taxable Social Security income,
Active trade or business income,
Gain on the sale of active interests in a partnership, S corporation, or limited liability company (LLC),
Income from tax-exempt municipal bonds,
Income from qualified annuities,
The portion of capital gain excluded from tax on the sale of a principal residence.
Note a few important distinctions involving these items. A gain from the sale of a passive activity, such as rental real estate, is counted as net investment income when you compute the 3.8% Medicare surtax. But any gain from the sale of a business interest in which you actively participate is excluded from the calculation.
2. Modified adjusted gross income (MAGI). You’ve probably seen this term before because it’s a common theme in the tax law. But don’t assume you know exactly what constitutes MAGI. Actually, three definitions of MAGI may be found in the tax code, so it’s easy to be confused.
For purposes of the 3.8% Medicare surtax, MAGI consists of the amount of your adjusted gross income (AGI) calculated on page one of your Form 1040 after certain modifications are made, plus any foreign income. Some of the most important modifications include reductions from AGI relating to:
Job-related moving expenses,
The deductible part of self-employment tax,
Self-employed health insurance deduction,
Health savings account deduction,
Penalty on early withdrawal of savings,
Self-employed SEP, SIMPLE, and qualified plan contributions,
Student loan interest deduction,
Tuition and fees,
Domestic production activities deduction.
Therefore, your MAGI may be much lower than your AGI, depending on your situation. In turn, this could reduce the 3.8% Medicare surtax you’re forced to pay.
3. Threshold. The basic threshold amounts for individuals are relatively easy to understand. The annual amount is $200,000 for single filers and $250,000 for joint filers. For example, if a couple filing jointly has a MAGI of $300,000, the excess of the MAGI over the threshold is $50,000.
However, with a trust or estate, things are slightly more complicated. In this case, the threshold is the starting dollar figure for the top tax rate for trusts and estates ($12,500 in 2017). For instance, if the undistributed net investment income of a trust exceeds the dollar threshold by $100,000, the trust must pay a Medicare surtax of $3,800 (3.8% of $100,000).
Once you have the key terms down pat, you can focus on reducing or even eliminating the surtax that applies to your situation. For example, you might take advantage of installment sales of passive investment property or seek to shelter income through charitable trusts, insurance, or annuities. The administrator of a trust could arrange for distributions of income to beneficiaries, which reduces a trust’s taxable income. We can work with you and your tax advisor to help you understand your situation and take appropriate action.
This article was written by a professional financial journalist for Advisor Products and is not intended as legal or investment advice.